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INTRODUCTORY ECONOMICS 



BY 

ALVIN S. JOHNSON, Ph.D. 

Professor of Political Econoroy in the 
University of Nebraska 



NEW YORK 

SCHOOL OF LIBERAL ARTS AND SCIENCES 

FOR NON-RESIDENTS 

1907 



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Copyright, 1907 
By THE SCHOOL OF LIBERAL ARTS AND SCIENCES FOR NON-RESIDENTS 



PREFACE 

In a democratic State economic science should be for 
the many, not for the few. The science is admittedly a 
difficult one; and until a royal road through its domains 
has been found, there is ample justification for the publi- 
cation of a new text-book on economics, for the many 
excellent manuals now before the American public have 
not reached all classes nor met all needs. It has appeared 
to the writer that an economics text-book of moderate 
dimensions, dealing with only the more fundamental prob- 
lems of the science, and written, so far as this is possible, 
in the language of every-day life, would prove useful to at 
least a limited class of students, and especially to those 
students of mature mind who seek to gain an introduction 
to modern economic thought, but who are not in a position 
to avail themselves of the advantages of class-room instruc- 
tion. What students of this class — as well as many other 
students — most need is not a compendium of economic facts 
nor even an exhaustive treatment of economic principles, but 
a series of rigorous exercises in economic reasoning which 
will enable them better to organize the mass of practical 
economic knowledge that their daily experience affords. 

The distinctive character of modern economic theory 
consists chiefly in its method of applying the principles of 
diminishing utility and diminishing returns. The student 
who is thoroughly familiar with these two principles, and 
who is trained to recognize their operation in practically 
every economic problem, will be able to follow the reasoning 
of the most profound of the modern economists, provided, 
of course, that this reasoning is not rendered unintelligible 
by a special terminology. But it is not alone as an intro- 
duction to economic theory that training in the use of these 
two principles is of vital importance. Most, if not all, of 



IV PREFACE 

the problems of practical economic policy involve one or 
both of these principles. The writer is persuaded that by 
far the greater proportion of the fallacies that vitiate popular 
reasoning on economic subjects originate in disregard of 
these principles. His aim in the theoretical part of the work 
has therefore been to present rather a series of studies 
throwing into relief the operation of these principles than 
an exhaustive treatment of the topics discussed. This 
method involves the exclusion of many topics that are 
ordinarily presented in an introductory treatise ; it involves, 
further, a degree of repetition that can be justified only if it 
attains its purpose in making the student thoroughly con- 
versant with the laws of diminishing utility and diminishing 
returns. 

The teacher of economics will observe that very little 
use has been made of the terminology of the Austrian school. 
This does not imply that the writer regards that terminology 
as useless ; on the contrary, he believes that in the develop- 
ment of some such special terminology lies the hope of sub- 
stantial progress in economic theory. It seems, however, 
unfair to the student to cumber the pages that he is to read 
with unfamiliar terms, the mastery of which will avail him 
little unless he is to devote himself to advanced theoretical 
study. 

It will further be observed that no attempt is made to 
group the chapters of this manual in "Parts" or "Books." 
The traditional fourfold division of the science is not 
suited to a theory which explains distribution in terms 
of production and makes frequent use of the concept 
value in its discussion of production. The division of the 
science into Statics and Dynamics, proposed by the author's 
friend and former teacher. Professor John B. Clark, while 
doubtless of great value in a work which is complete in it- 
self, is too important an innovation to be conveniently em- 
ployed in a book of a purely introductory character. 

It is perhaps superfluous for the author to mention the 



PREFACE V 

names of the economists to whom he is especially indebted, 
since such indebtedness will be readily recognized in his 
pages. The theory of value presented is in large part de- 
rived from that of Professor von Wieser; the theories of 
wages and interest follow closely those of Professor Clark. 
The treatment of rent and capitalization is largely influenced 
by the writings of Professor Felter and Professor Seligman. 
In his discussion of monopoly value the author has made 
free use of the writings of Professors Marshall, Clark and 
Ely ; in his discussion of diminishing returns he has borrowed 
liberally from Professors Marshall and Carver. The discus- 
sion of banking follows that of the late Professor Dunbar ; 
the discussions of money and international trade follow the 
accepted classical models. 
Lincoln, Nebraska, Alvin Saunders Johnson. 

December, 1907. 



CONTENTS 



I. The Nature and Significance of Eco- 
nomic Science 3 

II. Utility, Value and Price 18 

III. Normal Price . 37 

IV. Monopoly Price 49^ 

V. The Cost of Production 64^% 

VI. The Law of Diminishing Returns . . 79 

VII. The Division of Labor 97 

VIII. The Concentration of Industry . . . 109 

IX. The General Law of Wages .... 120 

X. Influences Giving Rise to Differences 

in Wages 135 

XI. Capital 151 

XII. The Rate of Interest 164 

XIII. Rent and Capitalization 181 

XIV. Business Profits ^97/ 

XV. Money . 213 

XVI. Financial Institutions: The Bank . 234 
XVII. Other Financial Institutions . , . 254 
XVIII. International Trade and Foreign Ex- 
change 273 

XIX. The Regulation of International Trade 293 

XX. The Economic Relations of Government 317 



CHAPTER I 



The Nature and Significance of Economic Science 

From the earliest time of which we have any record 
a great part of the activities of man has been occupied with 
the production or acquisition of wealth — material objects 
and personal services upon the possession of which human 
welfare depends, or seems to depend. In the long ages of 
savagery and barbarism primitive man was engaged in a 
ceaseless struggle with nature for the bare means of exist- 
ence — food, clothing, and shelter. Limited as were the 
supplies of nature, a savage tribe never for a long time 
enjoyed them in peace; other tribes coveted the hunting 
grounds, or the bays where shellfish abounded; the rich 
pastures or the groves of fruit-bearing trees. Hence the 
difficulty of obtaining from nature the means of subsistence 
was aggravated by constant warfare between tribe and tribe. 
A struggle for mere existence against nature and against 
hostile tribes — such was the life of primitive man. 

From century to century, however, man learned to equip 
himself better for the struggle for existence. Tools, at first 
rudely wrought from stone, later from the metals, greatly 
increased his productive power. A yet greater step in ad- 
vance was made when animals were domesticated, and a 
certain and steady food supply took the place of the pre- 
carious products of the chase. The cultivation of roots and 
grains that had in their wild state yielded scanty returns to 
the gatherer marked another stage of progress. Methods 
were crude, and the tasks of pastoral and agricultural life 
exceedingly laborious — a condition which gave rise to the 
enslaving of captives taken in war. With the increase in the 



4 INTRODUCTORY ECONOMICS 

productive power of a tribe, at least limited classes were 
freed from the struggle for the merest necessities. A leisure 
class, using the term in a restricted sense, appeared; and 
with it the germ of culture and civilization. Thus pro- 
ductive power and civilization have advanced hand in hand, 
until to-day, in the most progressive societies, there are 
comparatively few whose days are altogether devoted to a 
quest for food and shelter. 

Although civilized man is for the most part liberated 
from the dangers of starvation and of death through ex- 
posure to storm and winter cold, his desire for the material 
objects and human services that constitute wealth is in no 
way relaxed. Merely to possess food sufficient to satisfy 
hunger does not content him; the food must be pleasing 
to the palate as well as nutritious. Warm clothing is an 
excellent thing; but civilized man demands that his clothes 
be of good appearance as well as comfortable. A sod house 
on the prairie is constructed with no great 'amount of labor 
and almost no expense; in such a house one may defy the 
worst storms of winter and the hottest winds of summer. 
Yet the modern dweller on the plains would scorn to live 
in such an abode; his home must present an appearance 
of comfort and prosperity. To stand well with one's fellows 
is to most men hardly less important than life itself, and in 
all human history an important factor in winning and retain- 
ing the esteem of others has been the possession of proper 
attire and other personal appointments. There is a standard 
of wealth consumption which each little group of associates 
in society are under some sort of compulsion to attain. If 
my neighbors and boyhood playmates all have fine houses, 
I cannot enter my humble dwelling without a sense of in- 
feriority. If they are well fed and well dressed and well 
housed, I would be as good as they are. If they are wise 
or learned or cultured, I naturally strive to emulate them in 
this respect. But one cannot be well clad or well housed, 
Qm cannot very well even be wise or learned or cultured, 



INTRODUCTORY ECONOMICS 5 

unless one can command a fair amount of wealth, an 
amount far in excess of the bare needs of existence. Under 
modern conditions wealth has become a means — though, of 
course, not the only means — to most of the things which one 
can desire. And as it is not in the nature of man to be 
content for any long time with what he possesses and what 
he has attained, it is inevitable that his desire for wealth, 
which is so potent a means for further attainment, should 
continue unabated. 

This desire for wealth is what is meant by the economic 
motive. It necessarily plays a large part in the lives of 
most men. It animates the purest and most unselfish as 
well as the most sordid. For the desire for wealth is a 
desire for means to ends, and these may be good or evil. 
The philanthropist who wishes to found a home for invalid 
children must have wealth, just as the voluptuary who de- 
sires a palace of all delights to please his jaded senses. The 
economic motive animates both; very likely the philanthro- 
pist desires wealth the more ardently. What differentiates 
the two is the end which the wealth is meant to subserve. 
To assert, then, that all men are in great measure actuated 
by economic motives is not to assert that all men are selfish 
or sordid. It is merely to assert that wealth has been placed 
between man and the satisfaction of most of his desires; 
that as he seeks to attain any end whatsoever, he will seek 
to possess the means to that end. 

Economics is the science which deals with such of the 
activities of man as spring out of the economic motive. 
It treats of the creation, acquisition, and use of wealth. The 
subject-matter for economic science, therefore, is to be found 
in every society — as well in the most primitive tribe as in 
the most advanced nation. Yet the facts of economic life 
have only recently been worked up into a systematic body 
of knowledge. For the beginnings of the science it is not 
necessary to go back more than three centuries, although 
fragmentary treatment of economic questions may be found 



6 INTRODUCTORY ECONOMICS 

in earlier writings. How can we explain this late develop- 
ment of the study of facts with which humanity has from 
the earliest time been concerned? 

Throughout the periods of savagery and barbarism men 
lived in small groups, which produced, through the chase, 
agriculture, and pasturage, practically everything that the 
members of the group consumed. Whether the group pros- 
pered or fared ill depended upon the weather, the fertility 
of the soil, the quantity and character of game, the relation 
to other groups — whether tribute was given or received. 
Within the group the relative welfare of each member de- 
pended to a certain extent upon his own prowess and effi- 
ciency; perhaps to a greater extent upon the tribal customs 
in accordance with which the common products of the group 
were distributed among its members. As conditions varied 
widely among different peoples, a general science of tribal 
economics would have been difficult to create. In the civ- 
ilized states of antiquity a somewhat similar condition 
rendered the rise of economic science impossible. Industry 
was based on slavery; the lord of landed estates produced 
by slave labor almost everything that was needed on the 
estate. His welfare depended upon the amount and fer- 
tility of the land he possessed; the number of his slaves 
and his skill in managing them ; the state of the weather, 
and freedom from hostile invasion. No systematic body of 
knowledge explaining the economic life of the people as a 
whole was developed, because there could scarcely be said 
to be an economic life of the people apart from that of the 
separate families. So, also, in the mediaeval villages. They 
were self-sufficing; the welfare of the community depended 
upon natural forces and the energy of the members of the 
community and their capacity for co-operation. Each indi- 
vidual depended for his welfare partly upon the same con- 
ditions, partly upon village custom in the apportionment of 
services and rewards. 

With the rise of modern trade a significant change took 



INTRODUCTORY ECONOMICS 7 

place in economic life. In greater and greater measure men 
engaged in production for distant markets, instead of for 
their own use. Under such conditions welfare depended 
not only upon the producer's energy and success in the cre- 
ation of goods. It depended also in large measure upon 
the price of the goods which were sent to market. The 
transition from production for one's own use to production 
for the market took place at various times in different 
countries and in different industries. In some branches of 
production it is only recently that the change has been 
effected. Thus the production of bread, formerly almost 
everywhere carried on in the household for consumption 
there, has in the cities become an independent branch of 
industry, carried on for supplying a market, just as the 
production of shoes, cloth or iron. 

The striking characteristic of modern economic life, then, 
is that men produce goods not for their own use, but for 
the market. The employee in a shoe factory will very prob- 
ably never wear any of the shoes he helps to produce; if 
the maker of clothes ever works on garments for himself, 
this is the exception to the rule of his daily labor. The 
farmer consumes little, if any, of the wheat which he raises ; 
the woolgrower rarely spins and works up into cloth for 
his own use the product of his flocks. The modern economic 
system is therefore called an exchange economy, for it is 
through exchange of goods that each man gets the com- 
modities which he needs. And with the rise of the ex- 
change economy a new set of laws of wealth and welfare 
have come into operation. The welfare of a farmer under'' 
modern conditions depends in some degree upon his own 
energy and intelligence, and in some degree upon the 
weather. But in a very large degree it depends upon the 
price at which he can sell his products. A high price of 
iron brings prosperity to all the classes engaged in the 
production of iron, as a low price involves them in loss and 
distress. And so with practically all members of modern 



8 INTRODUCTORY ECONOMICS 

society; their welfare is bound up with the prices of 
products. 

A farmer or a manufacturer is popularly said to "put a 
price" upon his products. In the majority of cases, how- 
ever, what the seller really does is to make a choice between 
selling at a given price or keeping his goods unsold. Except 
in rare cases there is a market price for goods which the 
buyers and sellers must accept if they desire to engage in 
business at all, and over this price no single person has any 
control. Yet prices do not exist apart from the action of 
men; they are the creation of man in society. Many per- 
sons, each acting with a view to his own interest, offer wheat 
for sale ; many persons stand ready to buy it. The price of 
wheat is fixed as a result of the offers and purchases of all 
persons who buy or sell wheat. It is therefore a social 
phenomenon — the creation of all society, or of a large part 
of it. And so it is with almost all prices. They are set 
by society. Hence the laws of price are properly called 
the laws of social economics, or of political economy. 

While each man produced goods for his own use, the 
tools and appliances which he used were of necessity simple. 
To cut enough wood for one's own use did not require a 
very expensive axe ; to furnish boards for one's own dwell- 
ing required only a handsaw, to be worked by two men. 
Spinning wheels and looms were likewise of the simplest 
make. These tools and appliances could be made by the 
workman himself, or secured through exchange at small 
sacrifice. Accordingly the laborer as a rule owned the im- 
plements he worked with. In early modern times, although 
production for the market had become fairly common, the 
means of production still remained in the worker's hands. 
The increasing demand for products, however, soon led to 
the introduction of more expensive tools, and at last to the 
invention of machinery. Every step in this direction made 
it more difficult for the worker to provide himself with the 
means of production. So these had to be supplied by per- 



INTRODUCTORY ECONOMICS 9 

sons of wealth — capitalists. Under present conditions man- 
ufacturing industry in almost all its branches requires so 
large an expenditure for equipment that no single laborer 
can work with his own tools and machines ; nor is it possible 
for a group of laborers to equip themselves for production 
through combining their small savings. The capital outlay 
for a mill employing a hundred workmen is usually far in 
excess of what a hundred workmen can accumulate. 
Industry must therefore be conducted by wage laborers and 
employer-capitalists. To a certain extent the employer and 
the capitalist have been further differentiated, the former 
borrowing capital from the latter at a fixed rate of interest. 
When the products are sold, whatever remains after paying 
wages and interest is a profit, the reward of the employer, 
or, as he is generally called, the entrepreneur or enterpriser. 

Under modern conditions, as we have seen, the prosperity 
of each industry as a whole depends largely upon the prices 
of its products. Within each industry the prosperity of each 
laborer, capitalist or employer depends in great degree upon 
the way in which the total product of the industry is divided. 
And here again we encounter social laws. There is a general 
rate of wages, which the laborer must accept if he wishes 
employment. In the same way, there is a general rate of 
interest. No one man exercises any appreciable influence in 
fixing these rates; they are the resultant of the actions of 
all those who have labor to sell or capital to lend, on the 
one hand, and on the other hand, of those who desire to hire 
laborers or to borrow capital. 

The prices of goods, the wages of labor, the rate of inter- 
est on capital, elude the control of any single individual. 
May they not, however, be controlled by combinations of 
individuals, or by the action of a sovereign state? Within 
limits this is possible. A trade union may force up the rate 
of wages ; a protective tariff may enhance the prices of many 
classes of goods. But there are limits beyond which com- 
bination and political action are unavailing — -limits which 



10 INTRODUCTORY ECONOMICS 

are set by social forces. What these forces are, how they 
Operate, how far they can be controlled, and with what 
results for society as a whole — these are the problems which 
social economics endeavors to solve. 

Social economics as a distinct science may be said to have 
taken its rise in studies concerning taxation and public 
finance. In early modern times the expenditures of govern- 
ment in most European states were steadily increasing. The 
various princes vied with one another in the splendor of their 
palaces and in the number and brilliancy of their personal 
following; the cost of maintaining the tranquillity of the 
nation at home and its dignity and influence in foreign lands 
became heavier from decade to decade. More than all, meth- 
ods of warfare by land and by sea were changing, and 
military success was coming to depend quite as much upon 
the size of the war chest as upon the valor of the soldiers. 
These new expenditures could be met only through taxation ; 
accordingly, it became a very practical matter for the states- 
man to devise means for increasing the prosperity of a 
nation in order to increase its capacity for paying taxes. As 
the precious metals seemed to be the most convenient and 
the most reliable form of wealth, it was the aim of the 
statesman to provide these in abundance. European coun- 
tries, having no important mines of silver and gold, could 
secure these metals only through foreign trade. Hence the 
kernel of early modern economic policy was the regulation 
of foreign trade, with a view to bringing into a nation large 
supplies of treasure. These regulations formed a system 
which in the end became burdensome in the extreme ; their 
futility and injuriousness were exposed in the latter half 
of the eighteenth century by the Economistes in France and 
by Adam Smith in Great Britain, whose writings first placed 
economics on a scientific basis. Through the nineteenth 
century economic discussion has progressed from one prac- 
tical problem to another — money and banking, trade union- 
ism, socialism, monopoly, etc. The chief function of the 



INTRODUCTORY ECONOMICS II 

science is still, as in its earliest period, to ascertain what 
economic policy of government will be most conducive to 
the general welfare. Although it is known as the "science 
of wealth,'' it is no part of the function of economics to 
instruct individuals how they may best acquire wealth. Its 
principal aim has been attained when it has thrown all possi- 
ble light upon the economic problems which a state, and its 
members as citizens of a state, have to solve. 

We have seen that under modern conditions the wel- 
fare of industries, and of individuals engaged in those 
industries, is largely determined by the social forces of 
price. The influence of price extends even further. In 
large measure the same social forces determine what each of 
us shall do; they fix one's place of residence as well as his 
occupation. If the price of glass is high, and remains high 
for a considerable period of time, high profits and high wages 
are possible in the glass industry. New establishments will 
be opened ; boys and young men who otherwise would have 
engaged in other industries become glass blowers. By fix- 
ing a high price on glass, society, as it were, decrees that 
more persons and more capital shall be devoted to that 
industry. If coal or other sources of power are excep- 
tionally cheap in a given locality, if conditions of transpor- 
tation are exceptionally favorable, large profits may be made 
by manufacturers in that locality; they increase their 
investments and new capital flows in from less favored 
districts. A city is built, and the population that was 
formerly scattered in hamlets and country is under a sort 
of compulsion to congregate there. Why are our cities 
becoming greater and greater? The social laws of price 
decree it. If we would understand just why modern society 
presents a given form, our inquiry must take into account, 
as perhaps the most important factor, these laws of price. 

Since the fixing of prices is a work in which all, or most 
of society co-operates, whatever affects any industry, for 
good or evil, must react in some manner upon all society. 



12 INTRODUCTORY ECONOMICS 

A dry year in India, with consequent shortage of crops, 
affects not only the Hindoo ryot, but also the British work- 
man, the farmer in Dakota or in Argentina. Large crops in 
the West, concurrent with high prices, exert a powerful 
influence, not only upon the interests of the local merchants, 
bankers and mechanics, but upon the manufacturing and 
financial interests of the entire country. The railways are 
prosperous, having an immense amount of transportation 
work to perform, and their stockholders receive large divi- 
dends, out of which they may improve their homes, or 
increase their investments in factories or what not, in every 
case creating a new demand for labor and extending pros- 
perity in ever widening circles to the remotest industrial 
classes in the land. A part of the surplus earnings of the 
railways may be turned to the extension of lines into new 
territory; to the double tracking of congested single lines; 
to the installation of new equipment, with the immediate 
result of an increased demand upon the rail mills and car 
works, and all the enterprises subsidiary to these. A crop 
failure, on the other hand, may disarrange the entire indus- 
trial mechanism and bring distress to the laborers and capi- 
talists apparently farthest removed from the immediate 
cause of the disturbance. 

An excellent example of the influences set in motion by a 
great economic event is given by Mr. David A. Wells in his 
Recent Economic Changes. In the year 1869 the Suez Canal 
was opened. Up to that time trade with the East Indies 
was carried on in sailing vessels, which rounded Cape Horn 
or the Cape of Good Hope with an expenditure of time of 
three to eight months. A large fleet was necessary to carry 
on this trade, and this consisted of sailing vessels, since it 
was impossible for the steamships of the time to make 
so long a voyage with the coal which they could carry. 
Because of the uncertainties attending so circuitous a voy- 
age, and because of the risk of war, vast stores of Indian 
and Chinese products were kept on hand in England, the 



INTRODUCTORY ECONOMICS 1 3 

natural emporium for this trade. There arose in England 
a great warehousing system, and a parallel development of 
banking, the warehouse receipts serving as excellent secur- 
ity for banking loans. After the opening of the canal, most 
of the commerce with the Indies passed through the 
Mediterranean. In this sea, and more especially in the 
Red Sea, the sailing ship was practically useless. Hence a 
great number of steamships were constructed, and an amount 
of sailing shipping of about two million tons was virtually 
destroyed. Ships that formerly would have done service 
for years rotted in the wharves ; others were sold at far less 
than cost to be used in other branches of trade. Persons 
whose property consisted in sailing vessels of any kind 
suffered heavy losses. Towns along the seacoast that had 
been engaged in building sailing ships saw their prosperity 
wane. Captains and trained seamen who had been employed 
on the East India ships were forced to seek other employ- 
ment. As the new method of transporting goods was 
relatively quick and certain, there was no longer any need 
for keeping anywhere in Europe large stores of India goods. 
Moreover, goods destined for consumption in the Mediter- 
ranean countries, and even in Central Europe, were no longer 
conveyed to England and thence distributed, but were landed 
at various Mediterranean ports. The warehousing system, 
accordingly, fell into decay so far as this branch of the trade 
was concerned, and the banking houses which had depended 
upon the warehousing business were involved in losses. On 
the other hand, the increasing demand for steamships 
brought prosperity to the towns where such ships were built, 
and to the laborers who were fitted for the work of steam- 
ship construction. 

Such were some of the immediate effects. No less im- 
portant were the remoter ones. It was found that a vessel 
constructed of wood did not well withstand the vibrations 
of the engines ; hence the iron, and later the steel, ship took 
its place. So long as ships were built of wood there were 



14 INTRODUCTORY ECONOMICS 

few countries better fitted for shipbuilding than the United 
States. Iron and steel were, however, far dearer in the 
United States than in England; moreover, American labor- 
ers did not quickly acquire the skill necessary for the suc- 
cessful construction of iron ships. Accordingly, the Ameri- 
can merchant marine was forced to give way before the 
British. American enterprise was diverted to other chan- 
nels, and has not yet returned to the sea. 

The same event hastened the development of steam navi- 
gation, with consequent cheapening of freight rates, in the 
trade between Europe and America, and this helped to 
enable the American farmer to flood the European markets 
with his produce. This greatly increased the prosperity of 
America; it gave cheaper food to the British factory hand, 
and in less degree cheapened food supplies in Continental 
countries. The European farmer, on the other hand, was 
forced to take lower prices for his products. In England, 
where American competition was keenest, the agricultural 
districts were involved in a depression from which they have 
not yet recovered. 

It would be superfluous to multiply examples to show the 
close interdependence of parts in the mechanism of economic 
society. What affects one part of the economic organism 
must inevitably affect other parts. And this it is that renders 
it difficult to devise plans for obviating the economic evils 
which remain in spite of the progress of civilization. 
Through legislation it may be comparatively easy to restore 
to vigor a decaying industry, and bring comfort and wealth 
to those engaged in it. But the effects of legislation of this 
nature will not be bounded by the industry which it is sought 
to aid. Suppose that we are moved to action by the decay 
of the old ship-building cities, which once sent vessels to 
every important port in the world, but which now are com- 
pelled to seek a precarious sustenance from the entertain- 
ment of summer boarders; by the shipyards closed month 
after month; by the efficient seamen forced to do odds and 



INTRODUCTORY ECONOMICS 1$ 

ends of work ashore. It would be possible, through lavish 
grants from the public treasury, to make the ship-building 
industry pay. We should see a great industry spring up; 
we should have the gratification of knowing that the 
American flag might be seen on every sea — very good 
things in themselves. What we might not see, but what 
would be none the less real, would be a sacrifice imposed 
upon each farmer and miner and mechanic in the way 
of taxation necessary to meet the drain upon the public 
treasury. 

Most of us have at some time speculated upon the apparent 
injustice in the distribution of rewards and services under 
the existing economic system. Is it right that the unskilled 
laborers, whose hours are long, and whose toil is hard and 
uninteresting, should receive only the smallest pittance, while 
the successful lawyer or architect receives a princely income 
for work that may afford him the greatest pleasure ? Many 
able thinkers have utterly condemned the existing economic 
system because of this inequality of rewards; they wOuld 
substitute a plan of sharing which would give to each accord- 
ing to the time spent or according to the degree of exertion. 
Certainly, this would increase the welfare of many who 
now have far too little; it might not seriously injure those 
who have more than is necessary for comfortable existence. 
Yet could such a change be made without setting in motion 
influences which in the end would leave the rich poor and 
the poor more wretched than they now are? The question 
is one that cannot be answered without a thorough study 
of the laws governing the production and distribution of 
wealth under modern conditions. 

It is now clear why economic study, though of recent 
origin, is prosecuted with more zeal than almost any other 
department of science. It is concerned with one of the most 
vital of all subjects — the general welfare. Without economic 
science the existing constitution of society cannot be under- 
stood ; unless based upon an adequate understanding of 



l6 INTRODUCTORY ECONOMICS 

economic laws, attempts at practical reform of admitted evils 
are likely to do more harm than good. 

By what method are we to proceed in order to arrive 
at an understanding of economic laws ? Not by systematic 
experimentation, as in other sciences, for when human wel- 
fare is concerned, experiments extensive enough to be of 
value are not to be thought of. Not by an investigation of 
the facts of history, for present conditions differ so widely 
from those of earlier periods that past experience throws 
doubtful light upon the problems of to-day. Moreover, 
history records what is seen ; but what is not seen, but still 
exists, is a no less important part of economic life. 

The essential phenomena to be explained are prices — 
prices paid for commodities, for labor, for the use of capital. 
Now, if we can grasp the forces that are at work determin- 
ing prices, we must make some progress, at any rate, toward 
an understanding of the laws governing modern industry. 
Shall our method then be to study prices as they actually 
exist? Unfortunately, while a study of the markets will 
show whether prices are rising or falling, it will not show 
what forces determine prices in general. Some other method 
of approach to the problem must therefore be found. 

Although no individual exercises a controlling influence 
over price, yet prices, we know, result from the actions of 
individuals. When I buy a loaf of bread, I take the price as 
I find it, yet by my action I contribute an infinitesimal part 
to the sustaining or increasing of the price of bread, and 
with it, the price of wheat. Thus we all contribute to the 
determination of prices. And much as we may differ from 
one another in other respects, in our economic conduct we 
are much alike. Practically every one seeks to obtain for 
his money the largest possible amount of gratification. Prac- 
tically every one seeks to sell his labor for the highest wage 
he can obtain, and to secure the highest possible rate of 
interest on his capital. Exceptions occur, it is true. There 
are those who have fixed ideas as to fair prices and fair 



INTRODUCTORY ECONOMICS VJ 

wages, who refuse to accept either more or less than what 
accords with their standards. But these exceptions are so 
rare as to be negligible. In business life, as a general rule, 
each man acts with a view to his own best interests. The 
problem, then, is to discover the principles underlying 
economic conduct — how our desires arise and develop, how 
they are limited, how they are compelled to adapt them- 
selves to the conditions of external nature. In this study we 
have a key to the actions of other men in our own motives. 

Though each man seeks to buy as cheaply as possible 
and to sell at the highest possible price, he soon learns that 
there are other men who desire to buy or sell like products 
or services. That is, he encounters competition. And where 
competition exists one cannot follow his own desires in fix- 
ing the prices upon commodities which he has for sale or 
wishes to buy. He must meet the low prices of competing 
sellers by equally low prices, or abandon the field to them. 
If he hopes to buy, he must make his offer as good as those 
of competing buyers. Competition is not everywhere 
present; but in the great majority of business transactions 
prices are fixed with some reference to it. A monopoly may 
control the whole supply of meat. The monopolistic seller 
need not fear that meat will be offered by competitors at a 
lower price. Yet if he fixes his prices too high, intending 
purchasers will supply a part of their need for food with 
other products. The seller of cereals and vegetables is in a 
sense a competitor of the meat monopoly. 

We may, then, assume that under existing conditions 
prices are fixed through the concurrent action of buyers and 
sellers, each of whom seeks to increase his wealth and the 
resulting gratification at the least possible expenditure to 
himself. We may also assume that the fixing of prices 
takes place under conditions of competition in the widest 
sense of the term. With these assumptions we may pro- 
ceed to an examination of the process by which the indi- 
vidual and society arrive at the prices of commodities. 



CHAPTER II 
Utility, Value and Price 

Man is distinguished from all other living creatures by 
the number and complexity of his needs. The lowest savage 
requires better shelter and more varied and nutritious food 
than his next of kin in the animal world. And the higher 
man rises in the scale of civilization, the more numerous 
and complex are his needs. 

Corresponding roughly with man's needs are his wants 
or desires. From his general need for nutrition springs his 
want for particular kinds of food, and for anything that 
may help him to secure these — weapons, tools, etc. His 
need for warmth and protection against storm gives rise 
to a want for a hut or a cave, and for furs and skins 
and whatever else may serve as clothing. Under primi- 
tive conditions it was only through cooperation with his 
fellows that a man could procure adequate means of subsis- 
tence and could protect himself against his natural enemies ; 
moreover, without the society of his fellows he would have 
been miserable. Next to the needs for the means of physi- 
cal existence then, man needed whatever would win him the 
approval and admiration of his fellows. Hence arose wants 
for objects of personal adornment and the like. Finally, 
various puzzling experiences created in him the belief that 
his life was subject to the influence of unseen beings, whose 
favor he needed to gain ; therefore he developed a want for 
things w^hich he believed would propitiate such beings. 

Thus from the earliest time man has desired objects 
which would satisfy his physical, social and spiritual needs. 
In general, the same classification of wants or desires holds 
to-day. But in the evolution of wants the clear distinc- 



INTRODUCTORY ECONOMICS 19 

tions of earlier conditions have become somewhat ob- 
scured. Leaving aside the want for objects ministering to 
spiritual needs — as in a sense beyond the realm of economics 
— it is plain that most physical wants have a social element, 
as most social wants have a physical element. The want 
for food is of course predominantly physical; yet most of 
us demand that in its quality and preparation it shall 
conform to the standards of the society in which we live. 
The want for jewelry was at first almost purely social; it 
remains predominantly so. But in the progress of time 
man has developed a strong sense of personal satisfaction 
in gold and gems — he desires them perhaps more for their 
mere beauty than for the envy and admiration they excite — 
and this esthetic element may in many cases quite supplant 
the original social element. 

Every concrete want of man is capable of complete 
satisfaction. But the different wants vary widely in their 
insistency and in the ease with which they may be entirely 
satisfied. The want for bread, for instance, is extremely 
insistent, yet easily satisfied. I must have bread, but I would 
not care to have even a petty baker's entire supply. Such 
a want is known in economics as an inelastic one. The 
people of the United States require a fairly determinate 
quantity of wheat for food, and this quantity they will 
strive to secure even at great sacrifice. Much more than 
this, however, would not be wanted at all, unless of course it 
could be sold in other lands, or some use other than the 
supplying of food could be found for it. On the other 
hand, the want for some classes of things is very hard to 
satisfy at all, although it is not absolutely essential that 
the want be satisfied. I can get on very well without pos- 
sessing paintings ; but I should like to have all there are 
in the Louvre. The people of the United States may live 
comfortably without having many art galleries; but it is 
almost inconceivable that they covild have too many. Such 
wants, then, are elastic. 



20 INTRODUCTORY ECONOMICS 

As the examples given indicate, it is as a rule the wants 
for objects satisfying physical needs that are inelastic, and 
the wants arising out of social needs that are elastic. The 
wants for so-called necessaries are inelastic; for luxuries, 
elastic. Civilization tends to develop the wants for objects 
satisfying social needs, and for luxuries of all kinds. Hence 
it may be said that the higher a people stands in the scale 
of civilization, the farther it is from the complete satisfac- 
tion of all its wants. 

Every man wants enough food to keep him alive; a 
quantity sufficient for this purpose he desires intensely. 
An equal additional quantity will keep him in good condi- 
tion; this quantity he desires only less intensely. Give him 
more food ; it may still please his palate, and satisfy a want. 
But a point is soon reached where the man wants no more 
food at all. 

So the want for a suit of clothes is hardly less insistent 
than the want for food enough for life. A second suit of 
clothes will be highly desired, even if of identical quality, as 
it may be worn when the first is soaked with rain or other- 
wise out of condition for wear. A third suit of the same 
kind would not be desired very intensely; a fourth, or at 
any rate a fifth or sixth, would be a superfluity. But if 
it is possible to vary the quality, the want becomes far more 
expansive. The social element becomes predominant; the 
man would dress at least as well as men in the social group 
to which he belongs, or of which he desires to become a 
member. Yet a point is eventually reached where neither 
increase in quantity nor improvement in quality is desired. 

It may then be stated, as one of the general laws of 
human nature, that each want is capable of varying degrees 
of satisfaction, that with each increase in the means of satis- 
faction the desire for additional means grows less, until 
a point is reached where desire is no longer felt. 

Whatever satisfies a want is a good, in economic termi- 
nology. Its power to satisfy wants is known as utility. 



INTRODUCTORY ECONOMICS 21 

It is, of course, plain that nothing has utility in this sense 
unless it is wanted. Utility is strictly parallel with want; 
human want for a certain object endows it with utility; 
and the degree of utility is measured by the degree of 
want. Before men knew the use of iron, iron ore had no 
utility at all; with every advance in the art of metallurgy, 
the utility of iron ore has increased. In the days of 
Marco Polo, the only utility that existed in the petroleum 
of Asia Minor arose from its use "to anoint camels suffer- 
ing from the mange"; now the progress of science and 
industry has endowed the same material with a very high 
utility. 

Utility, it is to be borne in mind, is not usefulness. 
Opium prepared for smoking, being ardently desired by 
the victims of the opium habit, has a very high utility, in 
the economic sense; but it is the reverse of useful. As a 
rule, whatever is useful has utility, but there is no close 
correspondence between the degree of usefulness and the 
degree of utility. 

We have seen that wants are capable of varying degrees 
of satisfaction. As utility is strictly parallel with want, con- 
crete goods, satisfying the dififerent degrees of want, have 
different degrees of utility. Three bushels of wheat may 
supply me with bread enough to sustain life through a year ; 
the utility of these three bushels — supposing I have no other 
source of food supply — is exceedingly great; I want them 
as I want life and all that life contains. It would not be 
easy to fix an estimate upon this amount of utility, but 
let us call it i,ooo;ir. Another three bushels would enable 
me to keep in fairly good physical condition ; but their util- 
ity to me is evidently less ; perhaps it would be lOO x. An- 
other three bushels might mean overfeeding; yet some per- 
sons are desirous of being overfed; hence I may still de- 
sire these three bushels, and thus endow them with util- 
ity, which may possibly be measured by io,i'. With an- 
other three bushels I might feed a cat and a dog; it would 



22 INTRODUCTORY ECONOMICS 

give me pleasure to have these as pets; therefore I should 
desire the additional supply of wheat, and it might repre- 
sent a utility of 5 x. An additional three bushels I could 
probably not use in any way giving me satisfaction. They 
would have no utility for me at all. 

Suppose that I find a particularly beautiful sea-shell. 
As it seems beautiful to me, it has utility to me. The amount 
of utility to me may equal 103;. Another shell will not be 
so much of an acquisition, but I shall still desire it. Its 
utility may perhaps be gy. Additional ones will give me 
less pleasure, but as the want for things of beauty is hard 
to satisfy, I may still experience a desire for a hundredth 
or a thousandth shell, and these would have some utility 
for me. There is, however, a point beyond which addi- 
tional shells would merely cumber my premises ; they would 
then have no utility. 

These examples assume, of course, that I do not un- 
dergo a change while I am acquiring these goods. If 
repeated examination of the sea-shell inspires me with an 
increasing sense of its perfection of form, I may desire 
a second even more than I desired the first. Its utility will 
be greater than that of the first originally was. But not 
greater than the utility of a first shell would be in my 
present state. 

So one's first experience of classical music may be less 
enjoyable than his second experience of the same kind of 
music. He has, in the meantime, become a more cultured 
person. But assuming that no opportunity for development 
in taste is permitted, the pleasure derived from the first 
hour of listening to good music will be greater than that 
derived from a second hour of equally good music. The 
utility of the second hour of music is less. And so we 
may accept it as a general rule that the utility of a unit 
of any kind of good diminishes as the number of such units 
in one's possession increases. 

In the foregoing examples it has been assumed that 



INTRODUCTORY ECONOMICS 23 

the quantity of the goods increased until no desire for fur- 
ther units existed. Most of the things which we desire 
are not to be had in superfluous quantities. Instead of hav- 
ing five units, each consisting of three bushels of wheat, 
let us assume that I have but three. The third unit would 
still have a utility of lo ;r. As this is the utility of the last 
or final or marginal part of my supply, it is called final 
or marginal utility. Suppose that I have only ten sea- 
shells, and that the utility of the tenth is 5 y. In economic 
language 5 j' is the final or marginal utility of sea-shells. 
Final utility, it is clear, is a very variable quantity; if the 
desire for a good increases, with no increase in the number 
of units of the good, final utility increases; if the desire 
remains the same, but the number of units of the good 
diminishes, final utility again increases. In the first example, 
if the third unit of wheat were destroyed, the marginal 
utility of wheat would at once become 100 .r. 

Conversely, marginal utility diminishes with decrease 
in want or increase in number of units. I might tire of col- 
lecting sea-shells, or the waves might wash up a wagon- 
load of them. In either case the marginal utility would 
shrink — perhaps to zero. 

But does any man really arrange his wheat or other goods 
in series of units and say to himself : "This unit is worth 
1000 x; without it I should starve ; this unit is worth 100 x, 
as my comfort and strength depend upon it; this unit is 
worth 5 X, for if I did not have it I should be compelled to 
do without my pets"? Not at all; the different units are 
just alike, and one is thought of as just as desirable as 
another. For practical purposes, the utility of one unit is 
the same as that of another. Let us suppose that there are 
four units of wheat, and that the last has a utility of 5 x. 
What is lost if any one of the four units is lost? Simply 
5 X. What sacrifice would one make to prevent the loss 
of any unit, even the one which would have been used to 
sustain life, and by itself was worth looow? A sacrifice 



24 INTRODUCTORY ECONOMICS 

not greater than 5 x. For if any other unit is lost, the least 
important one will be substituted for it, and the effective 
loss will be properly placed at 5 x. 

The utility of the last and least important unit, then, 
exercises an important influence in determining what util- 
ity one will in effect ascribe to any unit. For practical pur- 
poses the utility of any unit is exactly equal to that of the 
least important one. The utility of a unit, thus measured 
by that of the least important one, is called "effective utility." 

If the total number of units of a good is so great that 
the last one has no utility, the good has no effective utility 
at all. No one would do anything to prevent the destruc- 
tion of part of his supply; no one would give anything 
to increase his supply. Thus water, although a single gallon 
would have indefinitely great utility, if this were the only 
gallon available, is in most places so abundant that the 
last units of the supply have no utility. Therefore no unit 
has effective utility. 

Anything which a man can acquire or hold possession 
of, which is capable of satisfying a desire, and the available 
quantity of which is so limited that every portion of it has 
effective utility, is an economic good. To possess any such 
thing is an object worth incurring sacrifice for; and no 
one will be ready to suffer deprivation of it. All such goods 
constitute wealth. 

Economic goods may be classified according as they 
satisfy wants immediately or indirectly. Bread, clothing, 
dwelling houses and the like minister directly to wants; 
they exist only for direct use, or "consumption"; they are 
therefore spoken of as consumer's goods. Tools, ma- 
chines, raw material, land and the like serve as means to 
the production of goods having the quality of direct utility. 
They are accordingly known as producer's goods. Under 
modern conditions the distinction is hard to draw, because 
through exchange goods destined for immediate consump- 
tion may be used indirectly to procure other goods. Thus 



INTRODUCTORY ECONOMICS 2$ 

the baker's loaves are not consumer's goods to him, but 
means for procuring whatever he may wish to consume. All 
material goods used either as materials or instruments of 
production, or as means of acquisition through exchange, are 
classed as capital goods. 

In order to direct one's economic activities intelligently, 
it is important to know how the effective utility of one kind 
of goods compares with that of another. Suppose that a cul- 
tivator can produce, with the expenditure of one day's labor, 
two bushels of potatoes or one bushel of wheat. Should he 
spend his time in producing wheat, or potatoes, or both? 
If the effective utility of two bushels of potatoes is greater 
than that of a bushel of wheat, the rational thing is for him 
to produce more potatoes and to spend less time producing 
wheat. According to the law of diminishing utility, the 
effective utility of potatoes will decline as their quantity i*^- 
creases ; at the same time, that of wheat will increase, as our 
example assumes that labor formerly occupied in wheat 
production is diverted to the raising of potatoes. A point 
will probably be reached where a day's labor will produce as 
much utility in one branch of agriculture as in the other; 
and until this point is reached, the cultivator has it in his 
power to increase his welfare simply by making a more ra- 
tional distribution of his labor. 

But before one can rationally distribute his labor or other 
resources, he must have a definite notion of the relative ef- 
fective utilities of goods. He must measure the utility of 
one — the degree to which it seems desirable to him — in terms 
of the utility of the other ; or he must measure them both by 
a common standard. And this, of course, is easy to do. 
Think of any two objects. Which seems the more de- 
sirable ? That one has the greater utility for you. How far 
would one walk in order to get good No. i ? If he would 
walk twice as far to get good No. 2, the latter has twice 
the effective utility of the former. Any good, or any sacri- 
fice, may serve thus as a standard for measuring the com- 



26 INTRODUCTORY ECONOMICS 

parative utilities of goods. Under existing economic con- 
ditions, of course, the standard which most readily occurs 
to one is money. If one wishes to compare the utilities of 
wheat and potatoes, he naturally considers how much money 
he would give for a bushel of either. 

Now, the effective utility of a commodity, compared with 
that of some other commodity, or compared with some sacri- 
fice which serves as a standard, is value. Value is effective 
utility measured. And as effective utility is constantly fluc- 
tuating with changes in the amount of a good, or in the 
desire for it, value is also always fluctuating. 

We often hear of the ''real" value of a thing, or of the 
"intrinsic" value, as if there were some kind of value resi- 
dent in a thing apart from man's desire for it. Of course, 
there can be no such thing. The value of a thing to any 
person is its importance at a given time and place. 

Values will naturally be different for different persons. 
What is the value of my grandfather's watch ? To me, it 
may be equal to that of $i,ooo. Perhaps you would not 
give $io for such an antiquated timepiece. In less extreme 
degree the same things holds of every good. Some will 
place a high value upon an object; others a low value; and 
the one is as properly the true or intrinsic value as the 
other. 

But is there not a certain scale of values in which most 
persons agree, and has not this general value a claim to the^ 
title ''true value"? There is indeed something like a scale 
of values established, as it were, by common consent; and 
the economic activities of each seem directed toward making 
his own scale of values conform to that of society. How 
this social scale of values arises out of the purely personal 
values just described, it will be our next task to consider. 
It is of course self-evident that the social value does so arise. 
One can not conceive of society as such discovering values, 
and imparting them to individuals. 

Utility, as we have seen, is a quality with which an ob- 



INTRODUCTORY ECONOMICS 27 

ject is endowed b)?" virtue of a human want. This want 
may arise out of physicial or out of social need. If a par- 
ticular social need should disappear or change, certain of our 
wants would disappear or change. Certain classes of goods, 
destined to satisfy such wants, would lose their value, or 
undergo some change in it. There was a time when gen- 
tlemen clipped their own hair and covered their heads with 
wigs. To move in polite society, one had to follow this, as 
other customs. Hence there was a want for wigs, and these 
were endowed with effective utility and value accordingly. 
As the fashion of wearing one's own hair came into vogue, 
this particular kind of wig ceased to have either utility or 
value. Now it is clear enough that the great majority of 
those who followed the earlier custom could have had no 
personal need nor want for a wig. They derived the want 
from their associates. The custom, I suppose, originated 
with some bald-headed prince, who really needed a wig. 
And so it was transmitted from the court to the gentry, and 
persisted long after the reason for its existence had disap- 
peared. The value of wigs thus arose from a personal need ; 
it attained vogue through imitation, and by a similar process, 
faded out and disappeared. 

Suppose that I attend an auction of the efifects of an 
eccentric gentleman, who has led a solitary life collecting 
odds and ends of all kinds, among them some things of value. 
I find a painting that pleases me. I know nothing of art, and 
all that the painting represents to me is a group of dull, 
brutish persons, making unnecessarily hard work out of some 
simple agricultural operation. What is its value to me? It 
would be difficult to say ; certainly in my own mind the value 
is something very tentative. But finding that the picture can 
be had for no great sum, I resolve to buy it. I hang my 
acquisition in an inconspicuous place, for I am not sure 
whether I should be proud of it or ashamed of it. A friend 
who knows something of art calls upon me. Perhaps he 
takes merely a glance at the picture and says nothing. Its 



28 INTRODUCTORY ECONOMICS 

value to me shrinks to zero. But if he cries enthusiastically, 
"Ah! a Millet!" immediately its value for me expands in 
an extraordinary fashion ; what had been scarcely a valuable 
object at all becomes a priceless treasure. 

Here then is one reason why values for different per- 
sons tend to conform to the same scale. If I find that most 
of my friends think that a riding horse is dear at $300, 
I think so, too, although I might get more satisfaction out 
of the horse than they. Value is thus in large measure 
a matter of imitation. But before one can imitate, there 
must be something original to serve as a center of imita- 
tion; and in the matter of values, this must be the original 
personal value of some, arising out of effective utility to 
them. 

Moreover, though imitation brings about a certain uni- 
formity in the scales of values of different persons, it can 
not of itself make them absolutely alike. If most of my 
friends think that a particular horse is worth $200, I cer- 
tainly would not value it at $300, unless indeed I am a 
connoisseur in horseflesh and my friends are not. But I 
think the horse is cheap at $200, while my friends think 
it is dear. And this shows that in spite of all tendency to 
conform, I retain a scale of values that is peculiarly my own. 

So long as men lived in self-sufficing groups, producing 
whatever they needed for their own use, there was no other 
force than imitation which could make the personal valua- 
tions of one group correspond with those of another. But 
in an exchange economy a much more potent force making 
for the socialization of values exists. 

Suppose that two farmers, with adjoining fields, both 
grow potatoes and wheat. Farmer A may consider that a 
bushel of wheat is worth two bushels of potatoes ; Farmer B 
may consider a bushel of potatoes worth two bushels of 
wheat. Of course, such a divergence could exist only in 
case the two farmers were so far from a market that they 
could exchange their products only with each other. 



INTRODUCTORY ECONOMICS 2g 

Assuming such divergence, however, the natural re- 
sult would be, not that they would debate the relative justice 
of their views of value, but that they would trade. Farmer 
A could afford to offer Farmer B two bushels of potatoes 
for a bushel of wheat ; Farmer B could afford to accept even 
a half bushel of potatoes for a bushel of wheat. Exactly 
how much A would at first offer, we can not say, nor is that 
of much importance. What is certain is that he can, and 
probably will, offer terms that will be acceptable to B, and 
some bushels will be exchanged. 

Now, as A parts with some of his potatoes, the effective 
utility, and with it the value, of potatoes to him increases. 
As he gets more wheat, the effective utility of wheat de- 
clines. And the reverse will be the case with B, who is in- 
creasing his stock of potatoes and diminishing his stock of 
wheat. It may still be worth while for the two farmers to 
exchange more bushels; but it is not so much worth while 
as it was at first. In the end, exchange must cease, for 
each will value wheat in terms of potatoes exactly as the 
other does. 

Perhaps Farmer A has land that is very well adapted 
to potato production, while Farmer B's land is best fitted for 
the growing of wheat. In another year A will have a super- 
fluity of potatoes and B of wheat, and the process of ex- 
change will again be necessary to equalize values. So in a 
developed economic system the value of wheat as measured 
in some commodity universally possessed, in regions where 
it is produced, tends continually to fall below the value of 
it in regions where little wheat is grown ; and this it is that 
keeps up a constant exchange between distant regions. And 
this constant exchange, in turn, tends to eliminate the dis- 
crepancies in values. 

Returning to the case of the two neighbors, perhaps one 
has a cow which he does not care to keep, but the other 
would like to have ; while the latter has a harrow which he 
does not need, but the former could well use. Possibly A 



30 INTRODUCTORY ECONOMICS 

values the cow at twenty bushels of wheat and the harrow 
at thirty ; while B values the cow at thirty bushels of wheat 
and the harrow at twenty. Here is a good opportunity for 
a trade. Either one might give the other a certain number 
of bushels of wheat "to boot," in order to bring about the 
trade. At what terms will the exchange be made ? We can 
not tell. Nor will the exchange, at whatever terms, affect 
the relative values placed upon cows and harrows by either 
party to the exchange. It would be different if more cows 
and harrows were to be exchanged. In that case the scales 
of values of the two exchanges would tend to uniformity, as 
was the case with the potatoes and wheat. But very likely 
no further exchanges are to be made. So I may be able to 
buy for $25 a coat that I would regard as cheap at $50. 
Another coat at $25, however, might not seem worth more 
to me than $20; accordingly I refrain from buying it. 
Hence the coat which I do buy retains a personal value 
for me in excess of the value placed upon it by the seller. 
It is a value that as a whole refuses to be socialized. 
A similar state of affairs exists wherever one buys single 
goods, not quantities of like units, as in the case of 
wheat. 

In the examples that have been used in the last section 
it was assumed that both parties to the exchange had per- 
sonal values, arising out of his own wants, for both com- 
modities exchanged. This may have been the usual case un- 
der primitive conditions ; but now, when we produce almost 
exclusively for sale, the seller of a commodity must fix a per- 
sonal value in some other way. I may be a dealer in ladies' 
shoes. It is safe to say that for my personal use they have 
no value whatsoever. Yet when a prospective customer 
appears, I have just as definite a value, below which I would 
not sell the shoes, as I should have if I were trading off a 
pair of shoes that I might use myself. Whence do I derive 
this value? I know that if I do not sell shoes to this par- 
ticular buyer, I shall probably be able to sell them to some 



INTRODUCTORY ECONOMICS 3 1 

one else. And I will take no less for them than I think some 
one else will pay. If experience shows me that few persons 
will pay the price, I must alter my personal value, or the 
fashions will change, and I shall have a stock of unsaleable 
leather on my hands. 

Now it must be plain that this kind of personal value 
is entirely a secondary phenomenon. It is derived from the 
estimate of other men's personal values, arising from per- 
sonal needs. It has its importance ; but it does not explain 
the values that are actually placed upon goods. This explana- 
tion lies in the facts of direct personal valuation. 

Personal values, as we have seen, naturally vary widely 
with different individuals. We need not believe that any 
two persons would affix exactly the same valuation upon a 
particular horse. One man might value the horse, for his 
personal use, at $500; another at $50. Yet we find that 
for a certain grade of horses there is something like a uni- 
form value in terms of money—or price. Perhaps this 
money value, or price, is $250. In that case the personal 
values of $50 and $500 are both ignored. They have no 
influence upon the price actually set. 

Personally I should abhor the idea of ballooning. If I 
were to place a value upon balloons for my own use, it would 
be far less than nothing. Clearly my personal value of bal- 
loons has nothing to do with their price, which for a given 
grade may be $5,000. If I had a mild interest in this form 
of sport I might value a balloon at $1,000; yet I should not 
influence their price. Were I so passionately fond of bal- 
looning, and so plentifully provided with money, as to value 
a balloon at $100,000, this valuation would nevertheless be 
incapable of raising the price of balloons much if any above 
$5,000. It is clear, then, that some personal values count, 
and some do not, in the determination of prices as they are 
fixed in the market. 

To show just what it is that determines what personal 
values shall count in fixing market prices, we may employ a 



32 INTRODUCTORY ECONOMICS 

somewhat tedious and artificial example which is the com- 
mon property of modern text-books in economics. Let us 
imagine a horse market, in which there are six persons with 
horses to sell, and six persons each of whom would like to 
buy a horse. We will assume that the horses are as alike as 
peas, so that each buyer would as willingly have one as an- 
other. Of course each buyer desires to buy as cheaply as 
possible, and each seller desires the highest possible price 
for his horse. Each buyer has in his own mind a top price — 
the most he would pay under any circumstances — and each 
seller has a bottom price, below which he would absolutely 
refuse to go. Being rational men, the buyers carefully re- 
frain from letting their top prices be known ; and in the same 
way the sellers keep their lowest prices a close secret. We 
shall assume the fiction writer's omniscience, and set down 
the top and bottom prices of the buyers and sellers respec- 
tively, as follows : 



Buyers 


Sel 


lers 


A $ioo 


M 


$90 


B 90 


N 


80 


C 80 





70 


D 70 


P 


60 


E 60 


Q 


50 


F 50 


R 


40 



How many horses will be sold, and at what price? Of 
course if each of the buyers in the first column were shut 
up in a stall with the seller in the opposite column, all the 
horses would be sold, and at different prices. But we are 
assuming that all are in an open yard, and hear one an- 
other's bids and offers. Under these circumstances no buyer 
will pay more than another, nor will one seller take less 
for his horse than another. What price will actually be 
fixed can be seen by following out in detail the probable 
action of these buyers and sellers, 



INTRODUCTORY ECONOMICS 33 

Suppose A, a buyer, offers $40 as his first bid. 
R could afford to take it ; but as any of the other five buyers 
would be glad to get a horse at that price, they each offer a 
little more than $40. Competition for this horse goes on 
until the price is raised to $50. At this point two horses 
may be had; but there are six competing buyers, and the 
price goes higher. Thereupon F, who will pay no more 
than $50, drops out. He can exercise no more influence 
in determining the price of these horses than I can in deter- 
mining the price of balloons. Bidding goes on, and the price 
is forced up to $60. Three horses are to be had at this 
price; but there are still five buyers the price goes above 
$60, and E drops out. At last the price reaches $70. There 
are now four sellers willing to part with their horses at this 
price; and four buyers willing to pay the price. Imagine 
that bidding goes on, and the price rises to $71. D would 
then drop out, and four horses would be offered, with only 
three buyers. Any one of the four sellers would rather 
sell at $70 than have his horse unsold; bidding among the 
sellers, therefore, forces the price back to $70. Under the 
conditions this price represents an equilibrium between the 
values of the buyers and those of the sellers. 

Let us imagine, however, that before the sale is actually 
effected, another buyer, with a maximum valuation of $110, 
appears. The price will then be forced above $70, and D 
will drop out. It will not reach $80, however, for then five 
sellers will compete to meet the needs of four buyers. The 
actual price will be fixed somewhere between $70 and $80. 
If an additional seller, with a valuation of $30, were to 
appear, the number of buyers remaining the same, the price 
will drop below $70, but not quite to $60. 

Where competition exists, then, the price will be fixed 
at such a point that all that is offered at a given price will 
be taken at that price. If we define as demand the aggregate 
of offers of money for a commodity at a given price, and as 
supply the aggregate of the commodity offered at the same 



34 INTRODUCTORY ECONOMICS 

price, we may say that price is fixed at the point where de- 
mand and supply are equal. 

At a given time the aggregate demands for wheat at 
$2 a bushel may extend to one million bushels; but the 
sellers of wheat may be willing to place on the market 
two million bushels at that price. Manifestly $2 a bushel 
cannot be the price set by the market, for the owners 
of the second million bushels, not finding purchasers, will 
offer it for less. At a lower price, some sellers will drop 
out, and some additional purchasers will appear. At $1.50 
a bushel, perhaps fifteen hundred thousand bushels will be 
offered, and the same amount taken. $1.50 is then the price 
that will actually be set. 

Now, not a single buyer pays more for the wheat than 
its effective utility to him, measured in terms of money. 
Some pay less than they would be willing to pay. These 
have a personal value which does not correspond with mar- 
ket value, and which has only an indirect influence in deter- 
mining it. On the side of the buyers the personal values 
that count most are those of the purchasers who find it just 
worth while to buy. For these are ready to drop out at any 
increase in price, and so tend to hold it at a given point. 
These buyers are known in ecomonics as the marginal buy- 
ers. On the sellers' side, the personal values that count 
most are those of the sellers who find it just worth while to 
remain in the market, since with a fall in price, these would 
drop out. 

Yet while it is the buyers and sellers who are just ready 
to drop out with changes in price — the marginal buyers and 
sellers — who at a given time hold the price where it is, price 
changes may take place in spite of them, through changes in 
the wants of many purchasers, or through the appearance 
of new sellers. The introduction of the automobile resulted 
in a new demand for gasolene, and as a consequence the 
price rose, eliminating the purchasers who had before been 
in a price-determining position. If alcohol should be sue- 



INTRODUCTORY ECONOMICS 35 

cessfully substituted for gasolene for the same purpose, the 
price of gasolene would fall and a new set of purchasers, 
who formerly had nothing to do with fixing its price, as 
they did not desire it enough to buy it, would come to occupy 
the position of controllers of the price. 

In existing conditions we do not find ourselves in the 
presence of unpriced goods upon which a price is to be placed. 
Everything that one wishes to buy already bears a price; 
one accepts the price, or refrains from purchasing. I com- 
pare my personal value of anything — say a hat — with the 
value of the commodity in the market. If I decide that a 
hat is worth more than $5 to me, I purchase it if it 
is to be had at that price. Parting with some of my money, 
each dollar I have is worth more to me ; and hats are worth 
less. Thus I make my personal value approximate that of 
the market. If I am a seller of hats, and I find that $5 
are worth more to me than a hat, I willingly part with 
the hat at that price. Having m^ore dollars, one is worth 
less to me; having fewer hats, I am_ not so anxious 
to part with one. Thus by buying- and selling one makes 
his personal values conform more nearly to that of the 
market. At the same time, by taking a hat from the seller, 
I reduce by a trifle the member to be sold to other pur- 
chasers ; I make the hat sellers less anxious to sell, and con- 
tribute of my puny strength to draw up the general level 
of value of hats to my own personal value. So all of us 
who are purchasers are joining our efi:*orts to raise prices 
to a high level, although what we desire is low prices ; and 
all of us v/ho are sellers are exerting our combined strength 
to pull them down, although we are anxious to have high 
prices. Those of us who are least anxious to buy or to 
sell exercise an equalizing function; when the buyers' side 
prevails, and prices are rising, the least willing buyers drop 
out; and similarly with the least willing sellers, when the 
sellers succeed in pulling prices down. 

Of course if there is an increase in the number of buy- 



36 INTRODUCTORY ECONOMICS 

ers, or if the wants of existing buyers are intensified, then 
the buyers will be successful in raising prices. On the other 
hand, if the number of sellers, or the amount which each can 
sell, increases, the sellers prevail in the price contest, and 
draw the price down. Now it is very difficult to describe 
the influences that increase the number of buyers, or the in- 
tensity of their desires. But it is easier to describe the in- 
fluences determining the number of sellers and the amount 
they will sell. If for any reason the price of wheat should 
rise to $2 a bushel, we can predict with absolute certainty 
that the number of sellers will go on increasing until the 
price comes down. $2 for wheat is therefore an abnormal, 
or unnatural, price. On the other hand, if the price were 
fifty cents a bushel, we may count with certainty that in 
time sellers will drop out, and the price will rise. Fifty 
cents is an abnormal price, just as $2 is. Between the two 
prices must somewhere be one that is normal or natural. 
The market price will be constantly rising above or falling 
Delow it ; yet there will always be an increase of sellers when 
the price is above the normal, and a diminution in the number 
of sellers when the price is below the normal ; consequently 
the price will fluctuate about this point, never remaining 
long much above or much below it. The next chapter will 
show what forces fix the normal price, or, to use a nearly 
equivalent term, normal value, under conditions of com- 
petition. 



CHAPTER III 
Normal Price 

At the close of the last chapter it was indicated that 
although market prices are continually fluctuating, they nev- 
ertheless tend to rise or fall toward a certain point, which 
may be called the normal or natural price. A particular 
fabric comes into vogue; everybody must have it, and as 
there is not an indefinite amount of it, its price rises. Per- 
haps it was worth $i a yard before fashion touched it 
with its magic wand; the price may easily become $5. 
Now, is this price one that is likely to continue — even 
supposing that the fashion should be transformed into a 
custom, and the enlarged demand for the fabric should thus 
become permanent ? Would it be safe for one to buy large 
stocks of this cloth, with the expectation of selling them at 
$5 a yard? Would it be wise for one to put up a 
mill for the manufacture of this kind of goods, with the ex- 
pectation that the high price would continue? There are 
conceivable conditions under which one might prudently do 
these things ; but in most cases it would be very bad business. 
Most probably, the price would sink again toward the $1 
mark. In all likelihood $1 is about what that fabric will sell 
for in the long run. 

So it is with the great majority of the commodities sold 
on the market. Their prices may at any time double ; but in 
all probability this will be a transient phenomenon. If any- 
thing is sold at an extremely low price — a price that has 
rarely been known before — most probably this also is a 
transient phenomenon. And just as it would be bad busi- 
ness to buy large stocks, or build factories, in anticipation of 
the continuance of excessively high prices, so it would be 
folly to quit a business, or sell out all one's stock, because 



38 INTRODUCTORY ECONOMICS 

of excessively low ones. The business man who is most 
likely to succeed is the one who has a due appreciation of 
normal price and who directs his business, so far as it is 
concerned with a more or less distant future, in accordance 
with its laws. Normal price, therefore, is a phenomenon of 
the greatest practical importance. And in so far as it deter- 
mines the direction of the productive forces of society, it is 
of the highest importance to the student of economics, as 
well as to the man of affairs. This is true even though 
actual prices may at any given time be above or below the 
normal, and may perhaps never remain for an appreciable 
time at precisely the normal level. 

The supply of most commodities may in some measure be 
increased or diminished at the will of the producers. Many 
producers are in a position to increase their output by 
slightly enlarging their working force, or by running over- 
time. Some producers are engaged in the manufacture of 
a number of different commodities, or of grades of one kind 
of commodity. By discontinuing the production of some 
of these and concentrating their energies on a single one, 
they are able to exert an appreciable influence upon supply. 
Moreover, there are always some persons who are in doubt 
whether or not they shall enter upon a certain line of pro- 
duction ; still others, now engaged in that line of production, 
who are in doubt whether or not they shall go out of busi- 
ness. 

When the price of a given commodity is very high, fac- 
tories producing that commodity run on full time, or over- 
time ; factories that would otherv/ise have produced several 
other commodities turn all their energies in this direction; 
manufacturers who were in doubt as to whether or not they 
should go on producing, find their doubt stilled; and new 
producers are lured into the industry. And this makes for 
an increased supply and a falling price. How long will the 
expansion of business continue? 
^ The two factors determining the business conduct of a 



INTRODUCTORY ECONOMICS 39 

producer are price and cost of production.! In the cost of 
production are included the value of materials used up and 
the wear and tear and general depreciation of machinery, 
buildings, lands; interest on all capital used, whether bor- 
rowed, or owned by the producer; wages of all labor, 
whether hired or that of the producer himself ; premiums to 
insurance companies for the assumption of the risk of de- 
struction of buildings and stock; taxes, water rates, etc. If 
the price of a commodity exceeds its cost, including in the 
term all the above-named elements, the supply of the com- 
modity can be profitably increased. If the price just equals 
cost, there is no sufficient reason for either increasing or 
dimiriishing the supply. If the price is less than cost, the 
supply will diminish. 

Suppose that it costs an average manufacturer $i 
to produce a yard of woolen cloth. If he can sell it for 
$1, he will probably go on producing about as much 
this month as he did last. For this price enables him to pay 
his operatives, to pay interest on capital borrowed, to pay 
taxes and insurance premiums, etc. It also affords him as 
much of a reward for his labor of management as he could 
get if he placed his services at another manufacturer's dis- 
posal ; and as large a return on his own capital as he could 
get from any other equally safe investment. But suppose 
the price rises to $i.io. For every yard he can sell he gets 
ten cents over and above all costs. This amount we shall 
call a net profit. Of course he will desire to sell as many 
yards as possible. He will work his mill to its fullest ca- 
pacity; if he has looms that are pretty well worn out, he 
makes haste to replace them with more efficient machinery ; 
if he has been contemplating the erection of an annex to his 
mill, he pushes the work forward as rapidly as he can. 
Every other manufacturer in his line does the same. And 
in time the increased supply of the fabric forces the price 
down, until it reaches $i, where the manufacturer 
no longer has any reason for increasing operations. Possibly 



40 INTRODUCTORY ECONOMICS 

the price goes still lower and reaches ninety cents. This does 
not pay all costs, but the manufacturer may still continue to 
produce, as it may be better for him to pocket his loss than 
to let the mill stand idle. But it is plain that he will curtail 
operations wherever he can. He will discharge his least 
efficient workmen, and discontinue the use of the least effi- 
cient machines. Every other manufacturer, in greater or 
less degree, is doing likewise. So the supply falls away and 
the price rises toward $i. This, then, is the normal 
price — a price that just covers cost of production, using the 
term cost of production so as to include all the items enu- 
merated above. 

If the price of a commodity exceeds cost, then, forces are 
set in motion which tend to bring the price back to the cost 
level. Now, no producer wishes to sell at cost ; every pro- 
ducer desires an excess above cost, and the greater the ex- 
cess, the better he likes it. If a manufacturer can produce 
a certain fabric at a total cost of $i, and can sell it at 
$1.10, he enjoys a very comfortable net profit; and the same 
thing is true of all other manufacturers in the same line. 
And they might continue to secure this net profit if each 
one would but refrain from enlarging his output. There is, 
then, something illogical in the conduct of the several pro- 
ducers, viewed in a certain way. Each of them is anxious 
to get as large a sum of net profit as possible ; but the result 
of their action is that nobody long continues to get any net 
profit at all. 

The reason for this is that there are too many of them 
for any one to have a perceptible influence over price. 
Suppose our manufacturer increases his output loo per cent. 
Probably this would not reduce the price one-fiftieth of a 
cent a yard. Therefore he obtains nearly twice as large a 
sum of net profit as he would have done if he had kept his 
output unchanged in volume. The temptation to increase 
his output, then, is very strong; it is strengthened by the 
fact that he knows that every one of the other thousand pro- 



INTRODUCTORY ECONOMICS 4I 

ducers is subject to the same temptation; some will yield to 
it; then others, finally all. And those who yield first will 
be the ones who will get the greatest sum of profit. Under 
the circumstances, the best thing for the manufacturer to do 
is to yield to the temptation the moment it offers. 

And this is what must inevitably occur where competi- 
tion exists — where each producer may increase his output if 
he desires to do so. However much it may be against the 
interests of all the members of a group of producers to in- 
crease operations, it is to the interest of each one to increase 
his own operations, if the price of his products exceeds their 
total cost. 

Often, in American history, have different classes of 
producers planned a universal curtailment of production, in 
order to force prices above cost level and hold them there. 
At one time the producers of raw petroleum, at another time 
the producers of wheat, at still another time the producers 
of cotton, have beguiled themselves with such plans. If 
each cotton producer would plant ten per cent, less ground 
next year, the price of cotton would probably rise twenty 
per cent., and every producer would get more money for less 
labor. Perhaps the cotton producers may make a general 
agreement to this effect. Well, every producer who violated 
his agreement, and doubled his acreage, would get the benefit 
of the high price, and the additional benefit from an unus- 
ually large quantity to sell. Each producer, having his own 
interest at heart, and suspecting the integrity of the motives 
of others, would be under the strongest temptation to in- 
crease his output. Some would refrain from doing so; but 
enough would increase their acreage to keep cotton very near 
to cost price. 

But let us suppose that the cotton producers were able 
to bind themselves legally to diminish production, ten, 
twenty, fifty per cent., or that some Croesus should buy up all 
the cotton lands and fix production at the figure which 
seemed most profitable to him. In either case, prices would 



42 INTRODUCTORY ECONOMICS 

cease to hover about cost of production. They would be 
such as always to afford a net profit. Such prices, in con- 
trast with normal or competitive prices, are called monopoly 
prices. They are controlled by laws, but these laws are 
quite different from those which prevail in competitive in- 
dustry. To state the law of monopoly price will be the chief 
purpose of the next chapter. 

It is clear that the only reason why the value of a com- 
modity tends to equal its cost of production is the automatic 
increase or decrease of supply when price temporarily 
swerves away from cost. It has already been pointed out 
that through combination such an increase in supply as will 
reduce prices to cost of production may be prevented. If 
for any other reason supply is unable to change, the price 
of a commodity may remain permanently high, or perma- 
nently low. Let us assume that a certain country has only 
one armor plate works, and owing to a deficiency in the 
public revenues would prefer to cease strengthening its 
navy rather than pay a price for armor plate corresponding 
to cost of production. The cost to the armor plate manu- 
facturer may perhaps be divided into the following elements : 
Interest on capital invested in buildings and lands, fifty per 
cent. ; cost of raw material, fuel, etc., twenty-five per cent. ; 
wages of labor employed, twenty-five per cent. The price 
offered for armor plate, let us assume, is sixty per cent, of 
the total cost. This price will cover the cost of materials, 
labor, etc., and will yield in addition one-fifth of the normal 
return on the capital invested in buildings, machinery, land. 
If the owner of the plate works refuses to take orders for 
plate, he will have to close down his works ; in that case he 
will secure no return on his capital at all. Clearly, it will 
pay him better to continue production. 

But suppose the price offered for armor plate is only forty 
per cent, of its cost. In that case, if the owner of the works 
is paying his men exactly what they could get in other in- 
dustries, and is paying merely the market price for his raw 



INTRODUCTORY ECONOMICS 43 

materials and fuel, he will have to close down his works. 
For by continuing operations he would lose not only interest 
on his fixed capital, but would also incur a net loss on every 
dollar he paid out for labor or for materials. 

Conversely, if a period of financial prosperity should 
enable the nation to enter upon an ambitious naval pro- 
gramme, the price of armor plate might rise considerably 
above cost of production without inducing any one to put 
additional capital into such an industry, from which it could 
not easily be withdrawn in case prices should fall. As sup- 
ply would not increase, therefore, price might long remain 
above the level of cost of production. 

When a street railway line is constructed, it is expected 
that the receipts from fares will cover all costs of operation, 
together with interest on all capital expended in constructing 
the line. Possibly the traffic will be so much less than was 
anticipated that the receipts will do little more than cover 
costs of operation, leaving hardly any return for the capital 
sunk in the road. This capital cannot, however, be removed 
to a more lucrative enterprise. To raise fares, even if this 
were permitted by the charter of the company, might still 
further discourage traffic and reduce net receipts. The 
street railway line will therefore be compelled to operate at 
a loss, preferring a small return on fixed capital to none at 
all. On the other hand, if the receipts are far in excess of 
cost, including under that head interest on fixed capital as 
well as operating expenses, it will still be impossible for 
other capitalists to construct another line on the same street, 
and so reduce fares to the cost level through competition. 

Similarly, it cannot be said that there is any tendency for 
railway freight and passenger charges to approximate cost 
of production. For the most part, such charges are gov- 
erned by other laws than those of normal price. 

The laws of normal price operate wherever supply auto- 
matically increases or diminishes with increase or decline of 
price. And this is particularly the case with common manu- 



44 INTRODUCTORY ECONOMICS 

factures. In a manufacturing industry there may be i,ooo 
mills producing the same grade of goods and selling them in 
a common market at a uniform price. Fifty of these mills 
become so dilapidated each year, through age, that they are 
dismantled ; fifty mills of equal capacity must be put up each 
year in order to maintain a constant supply of goods. If 
prices are so low that not all costs of production are covered, 
no new mills are erected to take the place of those which are 
abandoned, and a part of the supply fails. If prices are 
above cost, instead of fifty new mills, there may be lOO, and 
the increased supply tends to draw prices back toward the 
cost level. 

In the case of agricultural products much the same thing 
is true. If the price of wheat is high this year, more land 
will probably be prepared for the wheat crop of next year. 
Of course, if the price has been low for a series of years pre- 
ceding, it may be assumed that it is only some chance occur- 
rence that has raised the price — a famine in India or in Rus- 
sia, a foreign war, or some other transitory cause. In that 
case the prudent farmer will hesitate about applying an un- 
due share of his energies to wheat production. The supply 
of wheat, for the next year, may not be materially increased ; 
and owing to a similar unanticipated cause, may sell at an 
abnormally high price. Abnormally low prices in any year 
may be ascribed, by most farmers, to transient causes, and 
may lead to no decrease in acreage. Thus, for a period of 
years the products of agriculture may respond very slug- 
gishly to the influences of price. 

Again, it is possible that the high price of wheat during 
a period of years may lead to an unduly great expansion of 
the wheat growing area. As a consequence, so much wheat 
may be grown that for another period of years the price 
will be abnormally low — too low to compensate the farmer 
for his costs. And thus it is not impossible that the price 
of a commodity may constantly be alternating between an 
abnormally high level and an abnormally low one. Yet the 



INTRODUCTORY ECONOMICS 45 

high price must in the end bring about a reaction, just as the 
low price must do so. And for this reason we may call such 
prices abnormal, as contrasted with a theoretical price which 
would not show a tendency to be followed by a reaction in 
either direction. 

It is often impossible to tell exactly what it costs to 
produce a particular commodity. Some comm.odities are in- 
variably produced together, as beef and hides, cotton and 
cotton seed, wool and mutton. In most great industries, it 
is found possible to make use of parts of the raw material 
that are ordinarily regarded as waste. Thus, in the refining 
of petroleum, besides the main product, kerosene, a host of 
by-products — gasolene, lubricants, tars, dyes, etc. — are pro- 
duced. How much does it cost to produce these? Nobody 
can tell. They could not be produced at all, in commercial 
quantities, were it not for the immense capital engaged 
primarily in the production of kerosene. Part of the cost 
of the use of that capital ought to be counted as cost of by- 
products. But it is not possible to say how great that part 
should be. No one can say how much it costs to produce 
hides, or cotton seed, or wool. In such cases, there is of 
course an ascertainable cost, and hence a definite normal 
value, of live cattle, of sheep, of unginned cotton, of petro- 
leum products as a whole. If the price of beef, added to 
the price of hides, is more than reasonable compensation for 
the cost of raising cattle, the business of cattle raising tends 
to expand. And so with other cases of joint products. 

Where the cost of a particular commodity is ascertainable, 
and any one is free to enter upon its production, the price 
constantly tends toward the level of cost. Cost, then, may 
be said to determine normal value. It is, however, to be 
borne in mind that cost itself is something variable and fluc- 
tuating. Cost of production in any industry is greater for 
some producers than for others. A given grade of cotton 
goods may be produced either in Rhode Island or in North 
Carolina. It may cost an average of ten cents a yard in 



46 INTRODUCTORY ECONOMICS 

Rhode Island, and nine cents a yard in North Carolina. 
Some Rhode Island factories are better than others ; perhaps 
the cost of producing the cloth is eight cents in the best 
factories and twelve cents in the worst equipped ones. And 
similar gradations may exist in North Carolina. So when 
we say that normal price is fixed by cost of production, 
exactly what do we mean? Average cost? Greatest cost? 
Least cost ? 

It may be supposed that a factory which produces at a 
cost of eight cents will run on full time, and with full work- 
ing force, if the price is 8^2 cents. If the price is ten or 
twelve cents, it can do no more, unless it can be expanded 
by the erection of an annex. Let us suppose that it would 
take a year to construct such an annex and get it into work- 
ing order. In the meantime the factory produces as much 
as it can when the price rises ; but so it would have done if 
the price had not risen. So far as this factory is concerned, 
the rise in price does not immediately create an expansion of 
supply that reacts upon the price. This factory, then, can- 
not be said to be in a position to control prices. 

But let us suppose that there are other factories which 
produce at a cost of nine, ten, eleven, twelve cents a yard. 
So long as the price remains at 8^ cents, none of 
these, w^e may assume, will be in operation. As soon as 
the price rises to nine cents, the factories producing at that 
cost will open their doors, and by increasing the supply of 
goods, will tend to check further rise in prices. If prices 
rise nevertheless, the factories producing at a cost of ten 
cents will begin operations, and will exert their influence on 
supply and on price. When the price rises to twelve cents, 
it will be the factories producing at this cost that will tend 
to check a further rise in price. When the price is twelve 
cents, the costs of production of the better equipped mills — 
those producing at eight and one-half, nine, ten, and eleven 
cents — have little to do with the determining of price. If 
the price rose a little higher, or fell a little lower, these f ac- 



INTRODUCTORY ECONOMICS 47 

tories would continue to produce exactly as much as they 
do when the price remains at twelve cents. They do not, 
therefore, regulate the supply. This the twelve-cent mills 
do, since they are ready to drop out, and reduce supply, if the 
price falls. 

It is not to be understood, however, that a manufacturer 
can say : "I produce at a cost of twelve cents ; I must have 
at least that price," and so force the price up to twelve cents. 
If the market demands that manufacturer's contribution to 
the supply, it must pay twelve cents for every part of the 
supply. The manufacturer in the least favorable position 
cannot fix the price at his cost. He can only withhold what 
he might have supplied, and so bring to bear upon the market 
some small pressure, making for higher prices. 

It is only in a restricted sense, then, that we can say 
that normal prices are fixed by cost of production. Those 
who produce at a cost of twelve cents, by their action in 
placing a product on the market or withholding it, make 
an attempt at holding the price at that point. Perhaps the 
task is too great for them; the price slips away; and those 
producing at a cost of eleven cents make an endeavor, by 
the same means, to hold prices at their cost level. They 
also may be unequal to the task, but at last the price rests in 
the hands of producers who are just able to hold it at their 
costs. We may think of these as being on the fringe or 
''margin" of production ; they are often called, in economics, 
the marginal producers. 

The price does not, however, rest permanently with the 
same marginal producers. Those producers whose costs are 
less than the price are continually reaping profits ; they invest 
them in new mills, equally well equipped, and borrow capital 
further to increase their productive capacity. In time they 
greatly increase their output, and this tends to reduce the 
price of the commodity. The producers who are holding 
the price at their cost level find the burden growing heavier 
and heavier; soon the price breaks away from them al- 



48 INTRODUCTORY ECONOMICS 

together, and is held for a time at the cost level of slightly 
more efficient producers. But the most efficient producers 
continue to enlarge their works; an increasing supply is 
thrown upon the market, and the price settles to a still lower 
level, where it equals cost to producers who formerly en- 
joyed a slight profit. In this way prices are continually 
gravitating toward the level of cost to the most efficient pro- 
ducers. 

It may therefore be said that for a short period of time, 
price is determined by the costs of production of those who 
produce at the greatest expense, but whose contribution to 
the supply is necessary in order that the existing demand 
may be met. In the progress of time, however, such pro- 
ducers are unable to hold prices at their cost level, and are 
forced out of business. The final adjustment — if it should 
ever be attained — would leave price at the level of cost to 
the most efficient producers, all of whom would stand on a 
plane of equality as to costs. 

This does not mean, however, that the price of a given 
commodity must continue to decrease. The cost itself may 
increase, for the more efficient as well as for the less efficient 
producers. As we have used the term, cost includes the 
value of raw materials and fuel ; interest on capital, whether 
fixed in land, buildings, and machinery, or invested in raw 
materials, etc. ; wages of all labor employed ; and a number 
of lesser items — taxes, insurance premiums, etc. Now, 
every one of these elements in cost is perpetually fluctuating 
in magnitude according to its own peculiar laws. The 
sources of raw material may be approaching exhaustion; 
wages and interest may be rising; taxes may be growing 
heavier. But while such an increase in costs may prevent 
the more efficient factory from producing as cheaply as be- 
fore, it burdens the less efficient proportionately. It cannot, 
then, prevent prices from tending toward costs to the most 
efficient producer. 



CHAPTER IV 
Monopoly Price 

As has been shown in the preceding chapter, the mech^ 
anism which keeps prices hovering about cost of production 
consists in the automatic adjustment of supply and demand. 
If price rises, supply increases, and thus price is forced down 
again. If then the supply of a commodity can be controlled 
by the producers, the price is also within their control. With 
this control, the producers are in the happy situation where 
they can, within limits, enrich themselves at their pleasure. 
It is no wonder, then, that producers and dealers from very 
early times have sought to bring supply under control. 
Joseph controlled the total supply of grain in Egypt, we are 
told; he was thereby enabled to charge whatever prices he 
pleased; and the prices he fixed were such that he got in 
exchange for his grain all the possessions that the Egyptians 
had. In ancient and mediaeval times, when roads were bad 
and the costs of carriage prohibitive, whoever should buy up 
the stock of grain in a town would practically make himself 
master of the town. He could measure out the grain in small 
quantities, charging whatever prices seemed good to him. 
Quite naturally, then, men desired to monopolize the neces- 
saries of life. There was great wealth to be gained in this 
manner. And quite as naturally, the townsmen, who were 
thus compelled to pay high prices, desired to hang the 
monopolists, or at least to put them in prison. 

Monopolies we still have; and few of us have much 
love for them. But the monopolists of modern times can- 
not charge such exorbitant prices as their mediaeval and 
ancient prototypes. The mightiest monopoly in the United 
States can draw to itself only a fraction of the wealth of 
the community. The prices which it can fix and the profits 



50 INTRODUCTORY ECONOMICS 

which it can enjoy are strictly limited by economic laws, 
although the limitations are not so narrow, perhaps, as we 
should wish them to be. 

Before considering what these laws are, we must exam- 
ine the conditions under which monopoly may arise. One 
possible way has already been indicated. All the producers 
of a given commodity may agree among themselves not to 
sell below a certain price, or, what would amount to the 
same thing, not to produce more than an amount so small 
as to command scarcity prices. If the number of producers 
is small — say half a dozen — such an agreement might stand. 
No one could materially increase his sales without attracting 
attention ; moreover, no one could increase his sales without 
an immediate effect on price. If the producers number 
millions, such an agreement would be empty words ; almost 
any one could violate it without detection, and without any 
appreciable effect on price. And the number of violators of 
the agreement would be so great that no control of supply 
or of price could be exercised. 

When the number of producers is small, then, there 
may be effective control of supply. But such control cannot 
long be retained unless new producers can be kept out of the 
field. 

The producers of cotton yarn of the higher grades are 
not so very numerous. It is therefore conceivable that they 
might agree to limit supply and force the price to a point 
paying a "fair" profit. But it is not a very difficult matter 
to build and equip a mill to produce a given grade of cotton 
yarn. If then the price were forced to a high level, new 
producers would soon appear. These v/ould enjoy the bene- 
fit of the high price, although to effect sales they would have 
to undercut the prices of the combine. The latter would 
have to reduce its prices ; the new producers would then cut 
still lower, and so on until the price had reached cost of 
production. Indeed, the price would almost certainly go 
lower than this, for the number of producers, each striving 



INTRODUCTORY ECONOMICS $1 

to get more customers, would have increased. The last state 
of the cotton yarn business, accordingly, would be far worse 
than its first. We have had in America not a few examples of 
attempted monopolies which in the end merely intensified 
competition. 

If the industry in question requires a very high grade 
of skilled labor, and the members of the combine control the 
whole supply of labor of this grade, the monopoly may rest 
secure until new labor can be trained for the shops of would- 
be competitors. If the only satisfactory way of training 
such labor is through apprenticeship under men already 
working in the trade, it becomes difficult indeed for a com- 
petitor to get an independent supply of labor. This situation 
might become a serious one in some industries were it not 
for the fact that it is not easy for one set of employers per- 
manently to control their workmen. The latter would know 
that at any time they could thwart their employers' schemes 
by accepting employment with competitors ; and this knowl- 
edge would be made good use of, in forcing constantly 
higher wages. Where monopolies of this kind have arisen, 
they have generally been broken up on account of disputes 
between the employers and their workmen. 

Some products depend upon supplies of raw material 
that are found in comparatively few parts of the earth, and 
in limited quantity. If a combination of producers can get 
possession of all or most of the mining or agricultural lands 
which are capable of yielding a certain product, they may 
win their desired freedom from the danger of new competi- 
tors. Anthracite coal, for example, is found in only a re- 
stricted area in the United States. A combination of 
capitalists of very great wealth might with comparative ease 
control the total output — and indeed, something of the kind 
now exists. Such a combination has nothing to fear from 
new competitors, although of course it must meet the com- 
petition of producers of other fuels. 

Where a combination does not enjoy the ownership of 



52 INTRODUCTORY ECONOMICS 

limited natural resources, it may yet attain much the same 
result through systematic intimidation of those who might 
desire to become competitors in its field. The combination 
may be very rich, and quite ready to lose money on some part 
of its sales whenever this may be necessary to stifle compe- 
tition. Let us suppose that there is a combination of the 
more important producers of coal who yet have nothing like 
complete ownership of the coal lands. There may be a 
number of small competitors whose natural market is a city 
which we will call X. Other markets, we will assume, are 
so far distant that cost of transportation prohibits their sup- 
ply from the mines of the small producers. The combine, 
on the other hand, may have mines from which it may supply 
the market X, as well as a host of mines supplying other 
cities. If then it desires to destroy the business of its small 
competitors, it may decide, for a while, to sell coal in X for 
less than the cost of raising it from the pit. This the com- 
bination can afford to do, because it is enjoying high profits 
from its monopolistic position in the supplying of other 
markets. Of course the small competitors can sell no coal 
at prices which will meet those of the combine; very soon 
they become discouraged and retire from business. Then 
the combine can raise prices of coal in X to a profit-yielding 
point. The small producers will probably not again attempt 
to compete, knowing that the same tactics will again be em- 
ployed to destroy their business. 

Of course, if coal were easy to transport, this method 
would prove very expensive to the monopolistic combination. 
An enterprising dealer in the town X, finding that the 
combination sold coal there at much lower prices than in 
town Y, might buy up coal in the former place and ship it 
to the latter. On every ton of coal sold in X, we have as- 
sumed, the combination is losing money ; and every ton sold 
in Y helps to depress the price there, to the further disad- 
vantage of the combine. In a sense, it would be underselling 
itself. 



INTRODUCTORY ECONOMICS 53 

Accordingly, some other method of destroying competi- 
tors must be employed when the commodities which it is 
sought to monopolize are of little weight and bulk, as com- 
pared with their value, and hence easily transported. Sup- 
pose that a monopolistic combination controls most of the 
manufacture of cigars, and that an overbold outsider, 
anxious to share the benefits of high prices, enters the field. 
He may place on the market an excellent brand of cigars, 
charging for them less than the combine charges for similar 
ones. The combine cannot lower the prices of all cigars in 
the competitor's vicinity, for in that case dealers will buy 
them up and express them to all parts of the country; and 
thus the combine would be inflicting losses upon itself. But 
there is another method which it will find efficacious. 

Let us say that the independent producer calls his brand 
of cigars the "Rex." It is his all ; his fate is bound up with 
its fortune. The combine has 500 brands ; it makes profits 
on all of them. Accordingly, it can afford to put out a new 
brand of cigars — say the "Regina" — for half the price of the 
Rex, though of as good quality, and place it on the market 
wherever the Rex is sold. Before long the Rex is no longer 
purchased; its producer goes out of business. Then the 
combine puts worse tobacco into the Regina, until at last, like 
all its other products, this cigar is dear at the price.* 

Some businesses, by their very nature, tend to come un- 
der unified control. The supplying of gas to a city is of this 
character. A dozen competing companies, in a great city, 
would be an intolerable nuisance; besides, the cost of pro- 
ducing and distributing gas would be vastly increased by 
such competitive supply. A single street railway system, or 
a single telephone company, is much more convenient, and 
can operate more economically than competing businesses 
could do. A majority of the towns in the United States are 

* For the above, and other methods employed by monopolistic 
combinations in keeping competitors out of the field, see Clark, 
The Control of Trusts, Ch. IV. 



54 INTRODUCTORY ECONOMICS 

served by only one railway ; and this is of course in the posi- 
tion of a monopoly. In most of the remaining cities there 
can never be more than three or four competing railways, at 
most; and these, by virtue of their small number and by 
virtue of the peculiarly disastrous effects of competition in 
the railway business upon the railways themselves — which 
we cannot in this place discuss — almost certainly operate 
under agreements as to charges. There is, then, a large field 
of modern business in which monopoly is natural; and in 
this entire field, barring the existence of statutes fixing 
prices and charges, the monopolist may fix his terms accord- 
ing to his own views of what is profitable to him. 

A monopoly may also be created by law. In certain 
countries the manufacture of tobacco is monopolized by the 
state. Since no one can purchase from any other seller, the 
state can charge such prices for tobacco as will give a rev- 
enue to the treasury. A monopoly created by law may be 
given to a private individual. Once this was done for the 
benefit of royal favorites ; but nowadays such a monopoly is 
given in return for some service to the public. A city may 
thus give a monopoly of the sale of refreshments in a public 
park; but the dealer is expected to pay for it, either in a 
lump sum, or in a percentage of his profits. 

But the most common kind of monopoly created by law 
is the patent. Invent a new kind of machine, a new process 
of treating raw materials, a new kind of fuel or way of 
utilizing fuel. If the invention is really new, the govern- 
ment, in most modern countries, stands ready to protect you 
for a certain number of years in the exclusive enjoyment of 
it. If it is an article for sale, you may manufacture it and 
sell it for whatever you can get. You may sell your right, 
and the buyer proceeds to enjoy the monopoly. This mo- 
nopoly is of the strongest ; all the power of the state can be 
invoked to keep competitors out of the field. 

The above are by no means all the possible ways by 
which monopoly control may be secured. They are only the 



INTRODUCTORY ECONOMICS 55 

more common ways. Now it must be plain that there will 
be a great deal of monopoly in a society like our own. Com- 
bines exist ; limited natural resources are controlled ; devices 
for intimidation of possible competitors have reached a high 
degree of perfection ; more and more businesses are develop- 
ing into a state in which, like the manufacture of gas for a 
municipality, they are natural monopolies. Patents, also, 
were never more numerous ; and as they often fall into the 
control of businesses having other sources of monopoly 
power, they are a potent cause of monopoly growth. 

We may therefore expect to find in actual business, be- 
sides the branches in which prices are controlled by cost of 
production, other branches in which the producers have more 
or less power to hold prices above cost of production. This 
power varies from monopoly to monopoly, according as com- 
petitors are excluded by a strong means or by weak ones. It 
also varies according to laws which have only an indirect 
connection with competition. 

Suppose that a monopoly has complete control of the 
salt that is to be sold in the United States. It may cost one 
cent a pound to produce it. At what price will the monopoly 
sell it? If the price is one cent, perhaps one billion pounds 
will be sold. If the price were raised to two cents, who 
would eat his food unsalted ? Who would economize salt in 
the least? It is safe to say that there are few persons in the 
United States so poor that they would not go on eating as 
much salt as before. And the same thing would be true if 
the price v/ere raised to five cents a pound — a price of which 
four-fifths would be monopoly profit. 

But not all the salt is for table use ; a large part of the 
total supply is used for live stock and for manufacturing 
purposes. If the price of salt rises, the use of it for 
these purposes will decline. When salt is very cheap many 
farmers scatter it on the ground for their cattle, or leave it 
in troughs with no shelter, where the weather devours more 
of it than do the cattle. High price would mean economy. 



56 INTRODUCTORY ECONOMICS 

So, at tvv'o cents a pound, probably not more than 900,000,000 
pounds will be used, instead of 1,000,000,000. At five cents 
a pound the amount taken might shrink to 800,000,000 
pounds ; at ten cents, to 700,000,000 ; at twenty, to 500,000,- 
000. Were the price forced up to $1 a pound, very likely 
great economy would be exercised even in the use of salt in 
human food. Perhaps not more than 80,000,000 pounds 
would be used. 

Now, while the monopoly would make the enormous 
profit of ninety-nine cents a pound at the last-mentioned 
price, this would be a very irrational price for it to set. The 
total profit from the sale of salt would, according to our as- 
sumed volume of sales, be $79,200,000. And this would be 
much better than selling 1,000,000,000 pounds at cost, or 
900,000,000 at two cents. The latter price would yield just 
$9,000,000 profit. At five cents the monopoly would get a 
profit of $32,000,000 ; at ten cents, of $63,000,000 ; at twenty 
cents, $95,000,000. So twenty cents is really a more profit- 
able price for the monopoly than $1. At twenty-five 
cents, however, 400,000,000 pounds might be taken ; and this 
would mean a profit aggregating $96,000,000. This, then, is 
a still better price than twenty cents, from the monopolists' 
point of view. Let us suppose that at thirty cents 300,000,- 
000 pounds will be taken. The profit at this price would 
amount to only $87,000,000. The price, accordingly, is too 
high; and the best price for the monopolist lies between 
twenty-five and thirty cents. 

Of course this would be an exorbitant price; and far 
more extortionate than any existing monopoly price. But 
given the conditions — a monopoly of salt — -extortionate 
prices could be collected. One must have salt ; he must have 
a certain amount of it. There is nothing in the world that 
can be substituted for it. And even if the price were exor- 
bitant, it would form no very large item in any one's expen- 
diture. No one would leave the country to escape the mo- 
nopoly. 



INTRODUCTORY ECONOMICS 57 

Let us suppose, now, that a monopoly has gained control 
of the entire supply of beef in the United States. Perhaps 
the cost price at which beef could be placed on the market 
is ten cents a pound. With beef at this price, the American 
people might conceivably eat loo pounds per capita — 8,000,- 
000,000 pounds in round numbers. At eleven cents, some of 
the poorest people would cease eating beef and use mutton 
or pork instead, or use less meat of any kind. Perhaps the 
amount consumed would fall to 7,000,000,000 pounds. That 
would give the beef monopoly a princely income — $70,000,- 
000. At twelve cents the amount consumed might fall to 
6,000,000,000 pounds; but this would yield a net profit of 
$120,000,000; and if the amount at thirteen cents fell to 
5,000,000,000 pounds, the profit would yet amount to $150,- 
000,000. Fourteen cents and 4,000,000,000 pounds would 
be still better for the monopoly — $160,000,000. But fifteen 
cents and 3,000,000,000 would be a step backward, for the 
profit would be only $150,000,000. Fourteen cents, then, is 
the most that the monopoly could wisely charge. 

Of course, if the demand did not shrink so rapidly as I 
have assumed, the maximum price could safely be placed at 
a higher figure. If the shrinkage were more rapid than I 
have assumed, fourteen cents would be too high. 

If it is the intention of the monopolist simply to ex- 
ploit the beef market for one year — to corner the present 
supply, make the most out of it, and then retire to live on his 
plunder — he may find that at fourteen cents there will be no 
greater shrinkage of demand than has been assumed in the 
example, and this will then be the best price for him to set. 
Most persons who are accustomed to this article of diet will 
continue to buy it even at the higher price. But in a year more 
and more of them will form other habits. A corner in beef 
organized in the following year might not be able to charge 
more than twelve cents without diminishing total net profit ; 
and in the third year a corner might not be able to charge 
more than eleven cents. Accordingly, a monopolist who 



58 INTRODUCTORY ECONOMICS 

does not mean to retire from business must generally avoid 
charging a price that would give the highest possible returns 
for one year. He must fix prices in such a way as to keep 
the bulk of his custom from year to year. And this is 
one reason why modern monopolists are less extortionate 
than the ancient and mediaeval "engrossers" of the neces- 
saries of life. As a rule, the modern monopolist hopes for 
steadily increasing profits from a growing business ; he there- 
fore cultivates his clientele through prices that are moderate. 

If a ring of speculators of immense wealth should buy 
up the entire American cotton crop, they could fix the price 
of cotton at twice the normal price, and yet sell most of it. 
Cotton fabrics would advance in price, but not proportion- 
ately, for many persons would go without cotton cloth rather 
than pay unreasonably high prices. The profits of cotton 
manufacturers would fall ; wages of cotton operatives would 
be reduced. The cotton manufacture would decline; many 
cotton operatives would go into other employments. Cotton 
production in Egypt, India, and Australia would be stimu- 
lated. It would take more than a year, however, for such 
adjustments to take place. In the meantime the speculators 
would have sold their cotton at high prices, and reaped their 
extortionate profits. The injury occasioned by the changes 
in cotton manufacture would fall upon the producers of the 
next American cotton crop. 

If a combination of capitalists were to secure possession 
of the entire business of petroleum refining, it would be no 
less easy for them to obtain exorbitant profits for one year. 
But the decline in consumption that would follow, when 
time had been given the people to provide themselves with 
other sources of light and power, would seriously impair the 
future profits of the petroleum monopoly. Now, no profit, 
however exorbitant, on a single year's sales, is to be com- 
pared with comfortably high profits for an indefinite series 
of years. Great fortunes are to be obtained through the 
permanent monopolization of the means of producing a cer- 



INTRODUCTORY ECONOMICS 59 

tain commodity, rather than through cornering the visible 
supply and exacting excessive prices, without regard to the 
effect of the policy on future sales. For this reason mo- 
nopolies of the permanent kind are continually increasing in 
number and importance, while it is only rarely that a tem- 
porary monopoly is successfully carried through. 

Of course there are some classes of consumers who will 
pay increased prices without a murmur, while other classes 
will not only feel greatly aggrieved, but will even refuse to 
buy, when prices are appreciably increased. To the rich it 
makes little difference whether beef is high or low. If the 
monopoly can array its customers in groups^ according to 
their readiness to pay high prices, it can grade its prices ac- 
cordingly. The classes that will endure only a slight in- 
crease in price are given prices so moderate that they con- 
tinue to buy, while the classes that are less apt to complain 
over an increase are forced to pay prices that yield a higher 
profit. This would be much better for the monopoly than 
to fix an average price which would drive away the former 
classes, and not exploit the latter to the highest possible 
degree. 

How then may a monopoly make such a division of its 
customers into classes according to their profit-yielding ca- 
pacity? One way consists in different prices for different 
localities. If there is greater per capita wealth in Califor- 
nia than in North Dakota, a monopoly would charge higher 
prices in the former than in the latter State, even allowing 
for all costs of transportation. Suppose that the cost of 
production of beef for North Dakota is ten cents and the 
cost of transportation practically nothing; the cost of pro- 
duction of beef for California we may assume is the same, 
and the cost of shipping two cents a pound. The beef may 
be sold in Dakota for eleven cents and for fifteen in Califor- 
nia — giving a net profit of one cent in the former State and 
three in the latter. Of course, the difference could be as 
great as this only in case shipping beef in small quantities is 



60 INTRODUCTORY ECONOMICS 

expensive; otherwise outsiders would buy beef in Dakota 
at eleven cents, ship it to California, and make a good profit. 
And here we have one limitation upon a monopoly's power 
to vary in its charges for different localities. The different 
cannot permanently remain at a figure which is greater than 
the sum an outsider would have to pay in transporting the 
monopoly's goods from the point where they are cheap to the 
point where they are dear. 

In the case of many goods, however, different qualities 
are sold to different classes of customers. The choicest cuts 
of meat go to one set of consumers, and in the remaining cuts, 
in order of toughness, to the various sets of consumers who 
have less to spend. Now the consumers of the cheapest beef 
may stand a slight increase in price before substituting some- 
thing else for beef; while the consumers of the best quality 
may see the price double before substituting even a cheaper 
grade. The far-sighted monopolist, then, instead of in- 
creasing the prices of all grades uniformly, will so distribute 
the increase of price as to burden each class of customers 
as much as they will bear without withdrawing custom. 

In some cases where no real differences in quality exist, 
the consumer is made to believe that there are such differ- 
ences. Some years ago — and perhaps to-day — there were 
several grades of salt in the market, selling at different 
prices. The manufacturer who produced them all has ad- 
mitted that they were all exactly the same. The classes who 
could afford to pay high prices for salt bought the grade 
that was alleged to be the best; those who could pay less 
bought cheaper grades. Thus the manufacturer, who en- 
joyed a limited monopoly, was able to make each class of 
customers pay according to ability. It is easy to see how 
far this principle might be carried in the case of such articles 
as soap, chocolate, canned goods.* It is a wise man who 

* Some excellent examples of this kind of juggling with the con- 
sumer's desire for good qualities are to be found in Professor Ely's 
Monopolies and Trusts, 



INTRODUCTORY ECONOMICS 6l 

knows what ingredients go into these commodities; and if 
the manufacturer, who must know, says that one is purer or 
more choice than another, what can you or I do but accept 
his statement and pay the higher price for the so-called better 
quality ? 

It must already be sufficiently evident that the monopo- 
list who wishes to get the very highest possible profit has a 
very complicated problem, even in the case of goods ready 
for consumption. In the case of goods that may also serve 
as means for further production, the problem is still more 
complicated. Let us take as an example anthracite coal. 
Part of the supply is used to heat dwellings and other build- 
ings ; part of it is used to provide power for manufacturing. 
Suppose now that in New York City, where smokeless fuel 
is required by public authority, and where it would be some- 
what difficult to find a substitute for anthracite, the price is 
forced up to $io a ton. The very poor might prefer to 
freeze rather than pay the price; but the great majority of 
the inhabitants of New York would continue to buy anthra- 
cite much as before. 

Now in all the great cities of the North Atlantic sea- 
board anthracite is extensively used in manufacturing oper- 
ations. If the price goes up to $io — almost double the ordi- 
nary price — many manufacturers will substitute coke or 
bituminous coal. If these are not to be had, factory after 
factory closes down, since manufacturers in this section have 
to sell their goods in competition with manufacturers in the 
Middle West, where bituminous coal is cheap. The great 
demand for anthracite for manufacturing can remain only if 
the price remains moderate. Exorbitant prices for this fuel, 
if made universal, would result in limiting the consumption 
of it from year to year. 

Why might not very high prices be charged in New 
York City, and more reasonable ones in the factory towns ? 
Of course, if the price were much higher in New York than 
in Newark or Paterson, enterprising teamsters would cart 



62 INTRODUCTORY ECONOMICS 

coal from those cities into New York. The difference in 
price between different places cannot greatly exceed cost of 
transportation. 

The profit of our imaginary anthracite monopoly then 
is bound up with the welfare of the manufacturing commu- 
nity. In like manner, a railway may be the only means 
of carrying goods to and from a given agricultural region ; 
but if it charges very high rates on what it carries, the 
region is soon impoverished; lands go out of cultivation; 
towns decay; and their inhabitants move to districts where 
better transportation conditions prevail. And with the 
ruin of local business would come the ruin of the railway. 
So narrowly are the charges of railways limited — even 
though they possess a monopoly — ^that in perhaps a ma- 
jority of cases they cannot charge more than will cover 
expenses and pay a reasonable return on the capital sunk in 
the road. 

To sum up then, even an absolute monopoly is limited 
in its power to extort money from the public. The more 
elastic the demand for a commodity — i. e., the more readily 
demand increases with a fall in price, or diminishes with a 
rise in price — the more moderate will be the price which 
yields the highest return to the monopolist. And the more 
permanent the plans of the monopolist, the less does he seek 
the maximum profit for a single year. 

Now, the demand for most commodities is growing 
more and more elastic. We have more wants to satisfy than 
our ancestors had; and if a monopoly gets control of the 
means of satisfying one want, and seeks to extort money 
from us by this means, we may leave this want unsatisfied 
and turn our attention to some other one which demands 
satisfaction only less insistently, and which we can gratify 
without paying tribute to a monopoly. At the same time, the 
monopolists are growing more and more far-sighted; they 
refuse to sacrifice steady profits through years to the desire 
for a huge profit for a brief time. Thus economic forces 



INTRODUCTORY ECONOMICS 63 

are at work limiting more and more the possibilities of vast 
monopoly profits. 

Yet the prices of goods controlled by monopolies would 
be considerably higher than competitive prices were the 
monopolies really absolute. There are, however, few even 
of the most powerful trusts that have gained anything like 
complete control in their fields. There remain competitors, 
often very active ones, ready to expand their output when- 
ever prices become very high. What an intelligent monopo- 
list will aim to do, therefore, is to fix prices high enough to 
make a good profit, but not so high as to give a great induce- 
ment to new producers to enter the field, nor so high as 
seriously to limit his market in the long run. 

While monopoly prices tend to remain above cost of 
production, yet there is always some relation between the cost 
of production and the price. There may not be an excessive 
difiference between the two. To arrive at a more thorough- 
going explanation of price, therefore, it will be necessary to 
analyze further the costs of production and to study the 
forces which fix the rates paid for the goods and services 
that enter into the work of production. 



CHAPTER V 
The Cost of Production 

The preceding chapters have shown that the costs of 
production play an exceedingly important part in determin- 
ing the values of goods. Commodities produced under com- 
petitive conditions tend to sell at cost ; commodities the pro- 
duction of which is controlled by monopolies sell above cost, 
as a rule ; but at prices which usually stand in a close relation 
to the costs of production. Accordingly, to carry our 
study of values a step farther, we must enter upon a study of 
the laws governing the costs of production. 

At the outset it is worth while to bear in mind that what 
is "cost of production" to one man or class of men is "in- 
come" to another man or class of men. To the employing 
producer who conducts an independent enterprise (and 
whom we shall therefore call the enterpriser) wages are sim- 
ply a part of the cost of production. To the workman wages 
are earnings, income. The enterpriser counts in his outlay 
or costs the interest on the capital invested in his plant. To 
the capitalist this same item is income. The price of the coal 
which is consumed in providing power represents nothing 
but an expense to the enterpriser; but to the coal mine op- 
erator the price of the coal represents gross income. A 
closer examination of this gross income shows that it con- 
tains a net income to the coal mine operator; wages of 
labor employed in mining; interest on capital invested in 
the business, and certain other items — a sum for the replace- 
ment of machinery and other apparatus worn out, taxes, etc. 
— which further analysis will show to be in part or wholly 
incomes to some one. 

But we are not concerned in this chapter with incomes 
as such; our immediate concern is with cost of production, 



INTRODUCTORY ECONOMICS 65 

Our point of view will be that of the enterpriser, whom we 
shall assume to be acting frankly with a view to his own 
interest, paying no higher wages or interest than he is com- 
pelled to pay. 

The materials that enter into production are commodi- 
ties, and their market value and normal value are determined 
much as the market and normal values of the commodities 
fit for immediate consumption. We may examine briefly 
the process by which cotton yarn, the material of the cotton 
weaving industry, is valued. A multitude of weavers desire 
to buy it; some of them would pay a price of lox per hun- 
dred pounds rather than go without it; others would pay 
only 5x per hundred pounds, A multitude of sellers stand 
ready to furnish cotton yarn; some may be willing to sell 
at 5x rather than not sell at all ; others may be willing to sell 
only if the price is lox. What price will actually be set? 
Just as in the case of commodities for direct use, the market 
price will be fixed at a point where demand and supply are 
equal — that is, where the amount offered at a given price is 
exactly equal to the amount that will be taken at that price. 

But the price fixed at any moment by demand and sup- 
ply may exceed the cost of producing the yarn, even in the 
mills of those enterprisers who produce at the greatest cost. 
In such case the output of cotton yarn will increase; the 
price will come down, until it just covers cost of production 
to those who are producing at the greatest disadvantage. If 
the price were to fall still lower, these producers would have 
to quit the business ; and this would reduce supply and thus 
of itself tend to force up the price of cotton yarn. But the 
same price may be high enough to give excellent profits to 
the more efficient producers; these continue to extend their 
business, and the increase in supply from this source may be 
more than an offset for the decrease resulting from the clos- 
ing of the less efficient mills. Thus the price gravitates 
steadily downward, resting momentarily at cost of produc- 
tion to the least efficient producers ; then sinking to the cost 



66 INTRODUCTORY ECONOMICS - 

level of slightly more efficient producers; finally resting at 
the level of cost of the most efficient producers of all. Thus 
it appears that we need no new law of valuation to explain 
the action of sellers of cotton yarn. They act just as they 
would if they were selling a commodity ready for con- 
sumption. 

Do the buyers of cotton yarn act just as do the buyers 
of commodities ready for consumption? Not quite. One 
consumer may get ten times as much satisfaction out of a 
barrel of apples as another. He may for that reason be will- 
ing to pay ten times as high a price. But one buyer of cotton 
yarn probably turns out just the same grade of cloth as an- 
other, and sells it for the same price. As one cloth manufac- 
turer thus sells at the same price as another, and buys mate- 
rial at the same price, why should one be able to bid a higher 
price for the material than another? It must be because 
other elements in the cost of production of cloth — fuel, labor, 
the use of capital — cost him less, or because he has greater 
skill in utilizing material or in organizing his labor force. 
We see, then, that there can hardly be such wide differences 
in the prices which different manufacturers of cloth can 
afford to pay for cotton yarn as in the prices different con- 
sumers can afford to pay for apples. 

Now let us see what would happen if, through a gen- 
eral increase in the demand for cotton fabrics, the price of 
cotton cloth should everywhere rise. All the manufactur- 
ers of cloth would at first enjoy a profit. To increase that 
profit each manufacturer would try to extend his business 
somewhat, and this would tend to bring down the price of 
cloth. But in order to extend the cotton cloth manufacture, 
more yarn must be had ; and our hypothesis did not include 
a simultaneous expansion of the spinning industry. The cloth 
manufacturers would have to bid against each other for the 
existing supply of yarn; the price of the yam would rise, 
until cloth again sold at cost. We see, then, that it is not 
merely because of competition in the sale of finished product3 



INTRODUCTORY ECONOMICS 6/ 

that such products sell at cost ; it is also because of competi- 
tion in the purchase of the elements of production. If the 
price of cloth is for a time much above cost the expansion 
of the cloth manufacture tends to lower the price of cloth 
and raise the price of yarn and other elements in cost, until 
the price of cloth and its cost are again nearly equal. 

Looking now at the manufacture of yarn, we see that 
such an increase in the price as we have assumed will give 
high profits throughout the industry, and consequently will 
give rise to an attempt on the part of each manufacturer of 
yarn to extend his output. But this he can do only by in- 
creasing his consumption of raw cotton. As the business 
expands, the price of yarn tends downward, and that of raw 
cotton upward, until no exceptional profits are left to the 
yarn manufacturers as a class. 

Such an increase in the price of raw cotton means high 
returns to the growers of cotton. These, we may assume, 
had been selling their cotton at a price which gave a fair 
equivalent for the cost of labor, of the use of agricultural 
implements, of fertilizers and of the use of the land. The 
price now exceeds these costs. If this state of affairs con- 
tinues, more men will desire to grow cotton, either buying 
cotton lands or renting them. As such lands, of the best 
quality, are not unlimited, the rental and the price of land 
will go up. Here again the cost of production rises with the 
price of the product. Part of the increase in cost of produc- 
tion may assume the form of increase in the price of fertil- 
izers ; and this part we could trace still farther if we desired. 
The part which represents increase in rental of land can be 
traced no farther, for there is no cost of production of land. 

In the example given above it has been assumed that 
labor cost and the cost of the use of capital remain un- 
changed, in spite of the expansion of the cotton industry. 
This assumption may or may not be justifiable. An increase 
in the number of laborers and an increase in the amount of 
capital invested in buildings and machines, or used in the 



68 INTRODUCTORY ECONOMICS 

purchase of materials and other suppHes, would necessarily 
attend any expansion of the industry. To secure the addi- 
tional labor and capital, the manufacturers of cotton cloth 
may be compelled to offer slightly higher wages and interest 
than they formerly paid. But the amount of capital to be 
had at the prevailing rate is enormous ; and the slight in- 
crease in demand from the cotton industry would hardly be 
able to exert a perceptible influence in raising the rate. The 
same thing would be true of labor. To attract more laborers 
to the cotton industry, it would be necessary to offer only 
a slight increase in wages, as it is fair to assume that before 
the changes in the cotton industry occurred, wages in that 
industry were roughly equal to those in other textile 
industries, or even to those in manufacturing industries in 
general, allowance made for differences in the skill required 
and in the relative agreeableness of occupation. In such 
case, labor cost may be regarded as fixed, or more correctly, 
as rising and falling with the general trend of social pros- 
perity, not with the expansion or decline of a particular 
industry. 

It sometimes happens, however, that a more intimate re- 
lation exists between labor cost and the fortunes of a single 
industry. This is the case where for some reason a definite 
labor force is dependent for employment upon one industry. 
Here we see a rise in the price of the finished product fol- 
lowed by a rise in wages. Other elements in cost may also 
rise, and take a share of the increased price, or they may re- 
main relatively stationary. 

Let us imagine that a new branch of production arises — 
say, the manufacture of wrapping paper from corn-stalks. 
A single factory is erected, and let us assume that it will be 
operated in the winter months only. Of course the factory 
will have to be located in the country, the source of raw mate- 
rial. And in the country there is a great deal of labor that is 
hardly employed at all in the winter months. At what rate 
will our manufacturer be able to hire this labor ? 



INTRODUCTORY ECONOMICS 69 

It is clear that the cost of living will have nothing 
to do with the wages fixed. Country laborers are paid 
enough in the open months of the year to carry them through 
the winter. What they earn in the paper factory is a net addi- 
tion to their annual income. They can work for nothing, and 
be no poorer than they were before the factory was erected. 
The work in the factory may be pleasant rather than other- 
wise. Nevertheless, it is safe to assume that some rate of 
wages must be paid. Perhaps a wage of fifty cents a day 
will provide the requisite amount of labor. If so, that is all 
the manufacturer will pay. 

Now, if the manufacturer gets his labor at such a low 
rate, he may make extraordinarily high profits. In this case 
other enterprisers are likely to go into the business. If the 
industry assumes extensive proportions, it soon drains off 
the supply of labor that can be had for fifty cents a day. 
Further expansion becomes possible only through an in- 
crease in wages which will tempt into the industry workmen 
who regard their ease as worth more than fifty cents a day, 
or who are earning at least that wage in caring for live-stock, 
etc. But profits may still be high, and new enterprisers may 
be continually entering the business. To secure laborers at 
all, they are compelled to offer wages slightly higher than 
those paid by the enterprisers whose business is already es- 
tablished. The latter, in order to retain their laborers, are 
compelled to meet the bids of their new competitors. Thus 
wages for this kind of work go up, until all the enterprisers 
are fully supplied with workmen. 

Any further expansion will be followed by a similar 
increase in competition among employers of labor, and a rise 
in the rate of wages will be necessary in order to induce less 
industrious workers, or workers having some alternative em- 
ployment, to enter the factories. But each expansion of the 
industry means an increased product thrown on the market, 
and, other things equal, a lower price for it. What with the 
rising of wages and the falling price of paper, it seems clear 



70 INTRODUCTORY ECONOMICS 

enough that the profits of the enterpriser must be dedining. 
Possibly the expansion will continue until wages have risen 
to $2. All will depend upon the amount of paper that will 
be taken at a given price, and the amount of labor available. 

From this example it appears that wages cost cannot 
always be regarded as a fixed element in the enterpriser's 
calculations. The same competition among enterprisers that 
forces prices down forces wages up. Of course if the enter- 
prisers were to combine, agreeing upon a harmonious line 
of action, they might hold wages down, through limiting 
the demand for labor, just as they may keep prices of fin- 
ished products up by limiting the supply placed on the mar- 
ket. And here it may not be amiss to remark upon a fre- 
quent defense of combinations and monopoly. "Competition 
in the sale of goods so reduces prices that it is impossible 
to pay fair wages to the workman." As a fact, increasing 
competition — the appearance of new enterprisers — is likely 
to force wages up while forcing prices down. A monopoly, 
limiting output and limiting demand for labor, may be able 
to pay high wages to its employees. But will it do so ? 

We may now take another example, which will illus- 
trate some further points in the law^ of wages cost. Let us 
assume that there is a city which has been devoted almost 
exclusively to the manufacture of iron and steel goods. A 
cotton manufacturer, visiting the city — Ironton, let us call 
it — shrewdly concludes that the iron workers must have a 
number of sisters and daughters and other female relatives, 
who are practically wasting their time, and who would be 
glad to earn a small income by cotton spinning and weaving. 
Accordingly he erects a mill at Ironton. Very likely he will 
get all the labor he cares for at twenty-five cents a day, while 
his competitors, in the established centers of the trade, are 
paying a dollar a day for the same grade of labor. 

It is true that other elements in cost may be greater in 
Ironton than in other centers. It may cost more to bring 
the raw material to that place, and to ship away the finished 



INTRODUCTORY ECONOMICS Jl 

product. Fuel may be more expensive; and the wages of 
the mechanics who erect the mills and set the machinery in 
working order may be higher. The salaries that must be 
paid to foremen and overseers may also be higher than in the 
older centers. But in spite of all this, the cost of producing 
a given grade of cottons at Ironton, with wages at twenty- 
five cents a day, may be twenty per cent, lower than the cost 
of producing the same grade in the older centers, while the 
selling price may be just the same. Of course this will give 
the enterpriser at Ironton large profits. Before long other 
enterprisers will begin to wonder why a cotton mill has been 
set up at Ironton ; and finding, upon investigation, what ad- 
vantages that city offers in the way of low costs, they too 
begin to erect mills there. 

The effect of the appearance of these new manufacturers 
at Ironton is to increase the demand for cheap labor. Pos- 
sibly there are so many women and girls who are ready to 
work for "pin money" that the new mills can be plentifully 
supplied with labor at the same price as has been paid by the 
enterpriser first in the field. But it cannot be a great while 
before the supply of twenty-five-cent labor falls short of the 
demand; enterprisers erecting new mills will have to of¥er 
a little higher wages to entice workers away from the older 
mills ; and these wull have to raise wages to the rate offered 
by the newcomers. The competition will continue until 
wages are so high as to induce a new set of workers to enter 
the mills. Costs at Ironton may still be abnormally low 
after wages have risen, say, to fifty cents a day. In that case 
the cotton industry at Ironton will go on expanding, until 
at last aggregate costs are as great at Ironton as in the older 
centers of the trade. This does not mean that wages will be 
just the same. They may be seventy-five cents in Ironton 
and $1 in the older centers. 

If coal had been cheaper, mechanics' services cheaper 
and more efficient, transportation facilities better, at Iron- 
ton than in the older centers of the cotton industry, the ej^- 



7^ INTRODUCTORY ECONOMICS 

pansion of the industry at Ironton would not have stopped 
when wages had reached the level prevailing in older centers. 
With wages at that level total costs would still have been 
less in Ironton than in the older centers ; and so the industry 
would have continued to expand, until the rise in wages com- 
pletely offset the other advantages in favor of production at 
Ironton. 

From this example we see that the rate of wages which 
competition of manufacturers tends to fix cannot be uni- 
form for the different localities where a given commodity 
is produced. Where other costs are relatively low, competi- 
tion will force wages to a relatively high figure, and vice 
versa. 

Now let us suppose that, while the cotton industry in 
Ironton is developing, woolen manufacturers decide to erect 
mills in that place. They know that the cost of labor in their 
factories must bear a close relation to cost of labor in the 
cotton industry. If they could make the work in the woolen 
mills easier than work in the cotton mills, they might count 
on getting labor at a trifle less. On the other hand, if work 
in the woolen mills were less agreeable than work in the cot- 
ton mills, wages would have to be slightly higher in the 
former than in the latter. 

The appearance of the woolen mills would have exactly 
the same effect upon the wages of the cotton operatives as 
the appearance of new cotton mills would have. The woolen 
manufacturers would offer wages sufficiently high to attract 
workers away from the cotton mills, and the cotton manu- 
facturers would be forced to raise wages slightly in order 
to keep their working force intact. Further, this develop- 
ment in the demand for labor in the textile industries might 
in the end react upon wages in other industries — even in 
the iron industry. As soon as wages in the cotton and 
woolen mills rose above the wages paid certain classes of 
laborers in the iron works, boys and young men would leave 
the iron works to learn to operate looms. The resulting 



INTRODUCTORY ECONOMICS 73 

scarcity of labor in the iron works would naturally raise 
wages there. 

If we wish to formulate, provisionally, a law of wages 
cost, we may say that, at a given time, wages in any industry 
must be sufficient to prevent workmen from leaving that in- 
dustry to seek employment in other industries in the vicinity ; 
and that if competition exists among different producing cen- 
ters, all supplying the same markets, wages in an industry in 
one center will rise or fall until, together with other costs of 
production, they equal wages plus other costs of production 
in the other centers where the industry is carried on. To give 
a numerical example, if in city A one hundred yards of 
cotton cloth cost $io, of which $8 consists of cost of ma- 
terials, fuel, interest on capital, etc., and $2, of wages ; and 
if in city B, which obtains the same price for cloth at the 
mill, all other costs amount to only $7, wages in B will rise, 
under competition, until labor cost amounts to $3. 

But may it not happen that an enterpriser is enabled 
to keep costs of production low by forcing workers in par- 
ticularly necessitous circumstances to accept a lower rate 
than is prevailing in the district ? And can he not undersell 
enterprisers who pay the prevailing rate, and so force the 
latter to cut wages? Assuredly there are employers who 
take advantage of the ignorance or poverty of their em- 
ployees, and pay lower wages than their competitors pay. 
It is evident, however, that no large business can long be 
conducted on such a plan. Other employers will in the end 
entice away workers thus underpaid. And it is evident that 
the unfair employer will not sell his goods at a lower rate 
than his competitors, and so force prices down. It is not 
through producing at low costs, but through increasing one's 
output, that one forces prices down. The unfair employer 
will find it difficult enough to keep his present labor force; 
he will hardly be able constantly to increase it by offering 
starvation wages. 

May not the cost of labor be increased through the de- 



74 INTRODUCTORY ECONOMICS 

mands of labor organizations? This question can only be 
touched upon here. If there is no organization of labor, 
and if active competition among employers exists, wages for 
labor of a given grade of skill will in the end be as high in 
one industry as in other industries in the same vicinity, 
allowance being made for agreeableness or disagreeableness 
of employment. General wages in one industrial center will 
in the end be what they are in other industrial centers, allow- 
ance being made for differences in other costs. Now, a 
trade union can help wages to rise to these natural levels: 
if it forces them higher, it is likely to destroy the industry 
of the places under its control. 

We may now consider how far it is true that the price 
of the use of capital, or interest, remains constant in spite 
of the expansion of an industry. We may imagine that in 
a certain district the rate of interest is low. An enterpriser 
engaged in an industry requiring large investment of capital 
may find that he can produce more profitably there than in 
a locality where interest rates are high. Of course this can 
be the case only if other elements in cost of production — 
wages, fuel, materials — are not so much higher than in other 
localities as to balance the advantage of low interest rates. 
Granting, however, that the low interest rates are not thus 
offset, the enterpriser will for a time enjoy low aggregate 
costs, and therefore high profits. But soon competitors ap- 
pear, who offer a slightly higher rate of interest for the capi- 
tal offered by local capitalists. Enterprisers in other indus- 
tries likewise seek to take advantage of the low interest 
rates, until the rise in interest eats up the margin between 
selling price and cost of production. 

It must be admitted that this example is more nearly an 
imaginary one than were the examples employed to illustrate 
the laws governing wages cost. Why should interest rates be 
particularly low in one locality ? Is there any reason why a 
person residing in Boston should loan his capital to Boston 
business men ? It is no more difficult, practically, to lend it 



INTRODUCTORY ECONOMICS 75 

to enterprisers in Pittsburg. For this reason interest rates 
on capital are pretty well equalized throughout the country. 
It is easy to find industries migrating to sections where labor 
is cheap, or where the cost of fuel or of raw material is 
low. But it is not easy to find an industry migrating to a 
certain point because interest rates are lower than at other 
points in the same country. It is less difficult for the capital 
to migrate than for the industry to do so. 

Not all capital, however, is embodied in forms which 
permit it to migrate from one industry to another. A part 
of the capital of the manufacturer consists in the land upon 
which his mill is erected. A much larger proportion of the 
capital of a farmer is invested in land. The capital of a 
railway company consists partly in rolling stock, which grad- 
ually wears out and must be replaced; it consists partly in 
right of way, in grades and tunnels, which have perpetual 
life, as it were. Capital which consists in goods that must 
be periodically replaced may at the moment of replacement 
be diverted to other industries. But capital which is em- 
bodied in permanent goods cannot thus change from one 
industry to another. 

What will determine the amount that an enterpriser will 
have to pay for the use of land, or of other forms of durable 
capital? In the first place, it is clear enough that he will 
have to pay what any other enterpriser will offer. If, for 
example, one wishes to rent a field upon which to grow sugar 
beets, he will have to pay as high a rental as other beet 
growers in the vicinity pay for equally good land. And this 
rental will have to be as great as wheat growers in the 
vicinity pay for the same quality of land used for wheat. 

Beet growers may find, after paying all other costs, 
that a considerable profit remains in their hands from the 
sale of their beets. In such case the industry will expand, 
new enterprisers converting wheat lands to beet culture. 
The increasing output of beets might conceivably reduce 
their price; but more probably, since an enormous increase 



"J^i INTRODUCTORY ECONOMICS 

in the sugar output of a given locality would yet be a very 
small addition to the world's sugar supply, the price of beets 
will remain fairly constant. If no difficulty is experienced 
in obtaining labor and auxiliary capital the expansion of 
the industry wull continue until all the lands especially well 
fitted for beet growing are given over to that branch of 
agriculture. If the beet growers still have a surplus profit, 
they will compete among themselves for land, each desiring 
to increase his acreage. Higher rents will be offered, until 
the extra profits of the enterpriser are absorbed by this 
increasing element in cost. 

Of course if the labor supply is limited, relatively to 
the demand for it in beet culture, the expansion of that form 
of agriculture will gradually force wages up. Possibly the 
rise in wages will swallow up the profits of the enterpriser 
before all the ground that is well adapted to beet culture has 
been taken. In that case the expansion of the industry will 
cease without occasioning a perceptible rise in rents. 

:We may now give our attention to another element in 
the cost of production of many commodities — ^the price paid 
for crude materials as they exist in nature before any change 
has been wrought in them by industry. To illustrate the 
laws governing the value of these crude materials, we need 
to go back to an early stage, when they existed in quantities 
far in excess of any need for them. The cost of bricks under 
such conditions would contain no element representing clay 
in the bank or trees on the hillside. It would consist solely 
in wages of labor employed in cutting and hauling the wood, 
in digging and mixing the clay and shaping the bricks, and 
in interest on capital invested in kilns and drying sheds, etc. 
Bricks might at a given time sell at a price in excess of these 
costs; but this would cause new brick works to be erected 
and the price of bricks would fall, or the rate of wages would 
rise, until bricks were selling at a price merely covering cost. 

As population increased the demand for wood for brick- 
making would increase, as would also the demand for wood 



INTRODUCTORY ECONOMICS "J*] 

for other purposes. In time the proprietor of woodlands 
would see an end of the supply within easy distances, and 
would demand a price for wood in the tree. Here, then, 
would be a new element in the cost of bricks. Further 
growth of population might make the supplies of suitable 
clay seem insufficient to meet all demands, present and pros- 
pective. The owner of clay deposits could therefore demand 
a royalty for every cubic yard of this material. If the de- 
mand for bricks continued to increase, the price of wood 
and of clay would steadily rise. As soon as labor became 
so abundant that the brick-making industry could readily 
expand without materially forcing up the rate of wages, a 
constantly increasing proportion of the selling price of the 
bricks would be absorbed by the cost of the raw material. 

In an earlier chapter it was shown that price is continu- 
ally tending toward cost of production. We now see that in 
a sense cost of production itself is influenced by the price of 
finished products, a high price increasing the cost of certain 
elements in production, if not of all. It appears then as if 
we had been reasoning in a circle. Cost of production de- 
termines price; price determines cost of production. 

If we take a very broad view, we see that the value of 
anything which serves as a means of further production de- 
pends in large measure upon the price of all the products 
into which it enters. The value of labor thus depends largely 
upon the price of the products which it helps to create. All 
the other elements that cooperate with labor in production 
derive their values in a similar way from the finished prod- 
ucts. The price of all the elements in production, taken to- 
gether, tends to equal the prices of all products. Thus we may 
properly say that cost is constantly adjusting itself to price. 

If, however, we take a narrower view, confining our 
attention to a single industry, the costs of production may 
appear to be unvarying. If the price of cotton fabrics is 
high, competition in the end forces it down, instead of forc- 
ing wages and interest up. This is because the value of 



7^ INTRODUCTORY ECONOMICS 

labor and of the use of capital is derived not from the price 
of cotton fabrics alone, but from the prices of all commodi- 
ties into which these factors enter. And the cotton industry 
is not great enough to cause a perceptible rise in the wages 
of all labor and in the interest on all capital. So far as this 
industry alone is concerned, or any other single industry, 
price adjusts itself to cost. If, however, a certain element in 
cost is confined to a single industry, we see before our eyes 
the cost of a commodity adjusting itself to the price of a 
commodity, just as in the whole field of industry all costs are 
adjusting themselves to all prices. The classical economists 
were puzzled by these instances of costs that rise or fall with 
the price of particular commodities. As they did not reaHze 
that all costs, viewed broadly, thus rise or fall, they con- 
cluded that such shifting costs were not costs at all. 

It has been indicated that if, in one out of several cen- 
ters producing the same commodity, other elements in cost 
are relatively low, the cost of labor will be relatively high, 
and vice versa. In a district where the interest on capital 
and the cost of fuel are abnormally high, a manufacturing 
industry may often be carried on successfully in competition 
with other districts where capital is to be had at a low rate 
of interest and where fuel is cheap. But wages in the first 
district will probably have to be low to offset the high cost 
of the other elements. If any district enjoys the advantages 
of very cheap coal and low interest rates, wages in a branch 
of manufacture carried on there will rise to offset these 
advantages. 

We see then that the price of one element in production 
must bear some relation to that of the other elements. The 
rate of wages in special industries in particular districts is 
affected in some measure by the rate of interest in the same 
district. Whether the general rate of wages is similarly 
affected by the general rate of interest, will be a question for 
consideration in later chapters, when we shall seek to ascer- 
tain the laws governing these forms of income. 



CHAPTER VI 
The Law of Diminishing Returns 

In the last chapter we saw that one of the forces limit- 
ing the expansion of an industry is the tendency of costs to 
rise to the selling price of the product of the industry. The 
American cotton spinning industry may be very profitable 
this year — that is, the margin between the selling price of 
cotton yarn and the cost of producing it may be wide. But 
before long an expansion of the industry will take place; 
increasing demands upon the existing supply of skilled 
labor, of raw cotton, and of other factors in the production 
of cotton yarn will force the expenses of the enterprisers 
engaged in the industry to a higher level. 

We saw further that not all elements in cost show the 
same tendency to increase. In cotton spinning, part of the 
labor force is skilled, part of it unskilled. If the industry 
were to expand, say, by fifty per cent., a great strain would 
be put upon the supply of labor specially trained for cotton 
spinning. No particular strain would be felt by the supply 
of unskilled labor, for outside of the spinning industry 
enormous quantities of unskilled labor are to be had. The 
skilled labor might therefore for a time enjoy a large in- 
crease in wages, while the wages of unskilled labor would 
scarcely be affected at all. 

Similarly, such an expansion of the industry would 
represent a great strain upon the supply of raw cotton, 
which for a year could not be increased at all. Quite possi- 
bly the price of raw cotton would be doubled. The same 
expansion of the cotton spinning industry would result in 
an increased demand for coal for power. But the use of 
coal is so universal, and the volume of its consumption so 
vast, that the increased demand from the cotton industry 



80 INTRODUCTORY ECONOMICS 

would be a negligible factor in influencing its price. Coal 
would probably not rise perceptibly. 

For a somewhat different reason, the output of a single 
enterpriser can often be increased only at increasing cost. 
It is true that one enterpriser out of a multitude cannot 
force up the wages of labor against himself, as a whole in- 
dustry can do. Nor can he exert any perceptible influence 
upon the price of raw material and other supplies. But 
there are usually certain factors entering into his produc- 
tion that, so far as he is concerned, are either limited abso- 
lutely, or can be increased only at a disproportionately 
heavy outlay. In any agricultural section you may find an 
enterprising farmer forced to limit his operations to a single 
hundred acres. He could hire as many men as he pleased at 
$25 a month, the price he pays his one "hired hand." He 
could buy additional teams and additional machinery at no 
advance over the price of those he already has. Why 
should he not buy or rent additional land, and carry on a 
large scale business? Because all the adjoining lands are 
occupied by men who prefer to till them with their own 
labor and who would consequently demand a very high 
rental, if they consented to give up their land at all. Our 
farmer might be compelled to go a distance of three or four 
miles to get additional land at reasonable rates. Of course 
land could not be advantageously managed from such a dis- 
tance. Hence he is forced to content himself with his own 
one hundred acres. 

In almost any town you may find a bright and capable 
young grocer, conducting the pettiest corner grocery busi- 
ness. The possibilities of trade may be numerous; a store 
ten times as large might easily be supported by the potential 
custom. Why then do we find a little store? The young 
merchant might easily rent larger premises, without more 
than a proportionate increase in rent. He might hire as 
many clerks and delivery boys as he wished, without pay- 
ing a rate of wages in excess of the rate he pays to the 



INTRODUCTORY ECONOMICS 8l 

one or two already in his employ. What he especially 
lacks is capital. Perhaps he has $5,000 of his own. The cost 
which the use of this capital represents is merely the interest 
he could get in a savings bank — say, four per cent. With 
$5,000 capital of his own, he may be able to borrow another 
$5,000 at six per cent. For an additional $5,000 he would 
probably have to pay ten per cent., as the security he has to 
offer is not so good. It is unlikely that he can borrow more 
capital, no matter how high a rate of interest he may be will- 
ing to pay. The maximum business he can conduct, then, is 
one for which a capital of $15,000 will suffice. 

A small stream, flowing between high, rocky banks, 
may offer an excellent opportunity for the establishment of 
a factory, to be operated by water-power. Let us suppose 
that a manufacturer, acquainted with the advantages of the 
location, decides to erect a mill. He may be able to com- 
mand practically unlimited capital. Whether his mill will 
require one hundred hands or one thousand will make no 
difference in the rate of wages he will have to pay. Raw 
material can be obtained at least as cheaply in large lots as 
in small. Plainly, what will determine the size of the factory 
will be the power to be obtained from the stream. A ten- 
foot dam will give a certain power; a twenty-foot dam a 
much greater one, and every additional foot in height of 
dam means additional power. But there is an absolute limit 
to the height to which the dam may reach, without forcing 
the stream above its banks and ruining a large amount of 
property on the lower levels adjacent to it. There may also 
be limits of expense;, after the dam has reached a height 
of twenty feet, further addition to its height may imply such 
a great increase in its length and in the character of the 
materials required to stand the increased strain that the ad- 
ditional power is not worth its cost. 

It will not be necessary to multiply instances further. 
If the student will examine the various businesses with 
which he is acquainted he will observe that in a large pro- 



82 INTRODUCTORY ECONOMICS 

portion of them it is difficult, if not impossible, to duplicate 
all the elements in production without incurring dispropor- 
tionate expense. Businesses do increase in spite of this ; but 
the increase does not take place in a symmetrical fashion. 
The labor and movable capital may be increased while the 
land area is left unchanged ; the number of laborers may be 
increased while the capital remains fixed in amount. Some 
of the factors in production respond readily to the strain of 
an expanding business ; others show great resistance to such 
strain, but yield slightly ; others yield not at all. 

Let us return now to the case of the farmer, confined 
to his one hundred acres of tillable land. By his own labor 
and with a single team and the appropriate machinery he 
may till the whole tract. Fifty acres, we may imagine, are 
put into wheat, fifty acres into corn. In the time for sowing 
wheat, a few good days may be followed by a week of rainy 
weather. Half of the wheat field may be sowed in time to 
get the benefit of the wet weather ; the other half of the field 
may have to be left until the ground is dry, and so this part 
of the crop will lose the advantage of a fair start. Similarly 
part of the corn planting may be belated, with resultant 
danger to the crop from early frosts. There may not be 
enough dry days in the late spring to enable the farmer to 
keep his cornfield free from weeds. In harvest time, the 
chances of loss from delays in cutting and stacking the 
wheat are still greater. Of course these adverse chances 
may not be realized. The weather may be dry just when it 
should be; the rains may come just when they are wanted. 
But experience proves that the weather is not thus happily 
regulated. One year with another, our farmer will be for- 
tunate if he gets twelve bushels of wheat and forty bushels 
of corn per acre. 

Instead of tilling the whole tract with his own labor, 
the farmer may hire a man to help him. He buys an addi- 
tional team, plow, harrow, cultivator, etc., practically dupli- 
cating his stock of machinery as well as his supply of labor. 



INTRODUCTORY ECONOMICS 83 

The land can now be much more carefully tilled; it will 
almost surely yield a greater aggregate return. Will the re- 
turn be doubled? It would be unreasonable to expect this. 
More probably, the wheat yield will increase to fifteen 
bushels ; the corn yield, to fifty bushels. If wheat is worth 
seventy-five cents a bushel and corn twenty-five, what the 
farmer will gain from the additional labor and capital will be 
$112.50 worth of wheat and $125 worth of corn — $237.50 in 
all. Does it pay to employ the additional laborer? If he is 
employed for only six months of the year, at $25 per month, 
we must set $150 against the $237.50 for wages. If the ad- 
ditional capital amounts to $500, borrowed at the rate of 
five per cent., and if the wear and tear of capital goods — 
horses and machines — be placed at $50, we must add another 
$75 to the cost. Thus, in order to obtain $237.50 worth of 
wheat and corn, our farmer must incur $225 of cost. His 
net gain, then, is $12.50. 

Now let us imagine that he employs a second hired 
laborer, and invests an additional $500 in a team and ma- 
chinery. How much will be added to the crop? It is un- 
likely that the addition will be as great as that resulting 
from the employment of the first hired workman. We will 
assume that the wheat crop per acre is increased to seven- 
teen bushels, the corn crop to fifty-five. On the same price 
basis as we assumed before, the value of the addition to the 
crop will be $137.50, while the additional cost of tillage 
will be $225. We see that it does not pay to put three 
men upon the one hundred acre farm. 

A practical farmer might experiment in this way with 
a second hired workman; having discovered how unsatis- 
factory the result, he would in the future content himself 
with one hand. To satisfy our own curiosity, however, 
let us see what would happen if a third hand were employed. 
Perhaps the crop of wheat would increase to eighteen bushels, 
and the crop of corn to fifty-eight, an increase of value 
of $75. A fourth hand might increase the crop of wheat to 



84 INTRODUCTORY ECONOMICS 

eighteen and one-half bushels; that of corn to fifty-nine. 
There is no reason why every additional workman should 
not make some small addition to the crop, until the wheat 
crop had become fifty bushels and the corn crop one hundred 
and fifty. But it is idle to spend time in carrying out in de- 
tail a study of the results of a workman's labor, when these 
results are so much less than cost that no enterpriser would 
undertake to secure them. 

An important principle, involved in this example, may 
now be stated. From a given area of ground, an amount of 
produce can be obtained increasing with every increase in 
the labor and auxiliary capital employed in tillage, but in- 
creasing less than proportionally with the increase in labor 
and auxiliary capital. This principle is called the law of di- 
minishing returns in agriculture. 

If the rate of wages had been $io a month, all the 
other factors in our problem remaining unchanged, the gain 
to the farmer from the first workman hired would have 
been $102.50, instead of $12.50; the second workman, in- 
stead of representing a loss, would have given a net gain 
of $2.50. To employ a third hand, adding $75 to the total 
yield, but entailing an expense of $60 for wages and $75 
for interest and replacement of capital, would not have 
paid. 

It is to be observed that the rate at which the produc- 
tiveness of additional increments of labor and auxiliary 
capital declines varies for different lands and for different 
crops. The example which has been employed assumed a 
light, well-drained soil, such as is found in large tracts of 
the upper Mississippi Valley. If the hundred acre farm had 
consisted instead of heavy, boggy land, one man could 
hardly have kept it all under cultivation. If he had tried 
to do so, very likely his crop would have averaged less than 
ten bushels of wheat and thirty of corn. A hired workman, 
with auxiliary capital as in the earlier example, might have 
raised the product to thirteen bushels of wheat and forty of 



INTRODUCTORY ECONOMICS 8$ 

corn; a second hired workman might have increased the 
crop to sixteen and one-half bushels of wheat and forty-nine 
bushels of corn; a third, to eighteen bushels of wheat and 
fifty-seven of corn; a fourth, to nineteen bushels of wheat 
and sixty-four of corn. With wages at $25, it would 
still not have paid to put the second workman upon the land. 
But with wages at $10 a fourth workman could have been 
profitably employed, as the additional product arising from 
his employment would have been worth $143.75, while his 
wages, together with interest and replacement of wear and 
tear of capital goods, would have amounted to only $135. 
Possibly, under the circumstances, a fifth hired man might 
be employed upon the land. 

If the farmer is engaged in raising potatoes instead of 
corn and wheat, one hundred acres will be much more than 
he can handle alone. If he cultivates as large a part of the 
area as he can, say twenty-five acres, he may produce one 
thousand bushels. A hired workman could be set at work 
on another twenty-five acres, and add one thousand bushels 
to the product. Diminishing returns will not appear at all, 
for the field as a whole, until four are at work there. A 
fifth would probably add less than one thousand bushels, 
but might add nine hundred and fifty. Even a tenth might 
add five hundred bushels. Let the price be fifty cents a 
bushel : the tenth workman adds $250 to the product ; and if 
it costs $225 to pay his wages and the other expenses attend- 
ing his employment, it is well worth while to employ a tenth 
workman. With wages at $10, very likely a twenty-fifth 
workman would add more to the total product than the ex- 
pense which he would occasion. 

If wages remain stationary through a period of time, 
but the prices of agricultural produce rise, the number 
of laborers that may profitably be employed upon a given 
area of land will of course increase. If in our first example 
wheat had sold at $1.50 a bushel and corn at fifty cents, the 
increase in product arising from the employment of the first 



86 INTRODUCTORY ECONOMICS 

hand would have had a value of $475; from the second, 
$275; from the third, $150. Under the circumstances, the 
farmer would find it profitable to employ two laborers in- 
stead of one. The increase in number of laborers that might 
profitably be employed would be still more striking in the case 
of the farm with heavy soil, given a doubling of the price 
of the produce. If we assume high prices as well as low 
wages, the land of both grades will be cultivated with 
still greater expenditure of labor. And this is in some 
measure an explanation of the fact that where labor is 
cheap and the prices of agricultural products high, as in 
some of the countries of Europe, land is cultivated far 
more intensively than in places where labor is dear and 
the prices of produce low, as in the western part of the 
United States. 

The principle of diminishing returns, as it operates in 
agriculture, was first formulated by economists more than 
a hundred years ago, although practical men have of 
course taken account of it in their business conduct ever 
since agriculture became man's chief source of food. The 
applicability of the principle to land devoted to trading and 
manufacturing purposes was for a long time ignored by 
economists. This may be explained by the fact that 
formerly urban land was so cheap that the small amount re- 
quired for the erection of a shop or a factory represented 
an almost negligible element in the total costs of carrying 
on a business of this nature. The enterpriser rarely found 
himself forced to adjust his business with a view to obtain- 
ing the greatest possible use out of a definite amount of 
land. If his capital sufficed for so large a business, he 
purchased or leased a city block on which to erect his build- 
ings ; if his capital was small, he limited his use of land to 
a few lots. To-day conditions have changed in consequence 
of the extraordinary growth of the cities. The merchant 
who desires to carry on a business in the heart of the busi- 
ness district of a great city often finds himself restricted 



INTRODUCTORY ECONOMICS ^7 

to a given number of front feet. The adjacent lots are taken 
tip by establishments which show no disposition to remove. 
It is then a question how to conduct a maximum paying 
business upon a fixed ground space. 

One way of overcoming the limitation of ground space 
consists in erecting a very lofty building. Instead of con- 
tenting himself with a building of six stories, the enterpriser 
may push the height to fifteen or more. Perhaps it costs 
$600,000 to erect a six-story building. An additional $ioo,- 
000 may possibly give another story ; but more probably the 
seventh story will in effect cost more than this. To raise the 
building materials to this height is more expensive than to 
raise materials to a lower story. Moreover, a seven-story 
building is not merely a six-story one with a floor super- 
added. In planning the taller building, it is necessary to 
allow for greater strength of wall in the lower stories, in 
view of the additional weight to be borne by them. Greater 
care must be exercised to reduce risk from fire. In addi- 
tion to the increased cost of construction, there will be 
greater costs in connection with the permanent use of the 
seventh floor than in connection with the use of lower floors. 
More labor will be spent in carrying up the goods to be ex- 
posed for sale, and in carrying down the articles sold. More 
numerous and more powerful elevators will be required for 
the higher building. We may therefore place the initial cost 
of the additional floor at $120,000. The net profit from the 
use of this floor, allowance being made for the in- 
creased costs, may, however, represent a fair return on 
$200,000. The erection of the higher building is therefore 
profitable. 

An eighth floor would, in effect, cost still more than 
the seventh — $140,000, let us say. The cost of operation 
would also be increased. As there is ordinarily no reason 
why the business accommodated by this floor should be in 
any way greater than that accommodated by the seventh, the 
profit may be assumed to be less — say, a fair return on 



88 INTRODUCTORY ECONOMICS 

$180,000. A ninth floor may yield a fair return on $160,000 
and cost about the same sum. Here then is the limit to up- 
ward extension of the business. 

If for any reason the cost of construction should be re- 
duced, as through the substitution of steel frame for solid 
masonry, the height to which a building might economically 
be raised would naturally be increased. Let us suppose that 
the ninth floor, instead of costing $160,000, represents a cost 
of only $140,000. In this case a tenth floor, or even an 
eleventh, may be worth while. 

If the cost of construction remains unchanged but the 
rate of interest on capital invested in buildings falls, a tenth 
or eleventh story would perhaps be a good investment. As 
has been indicated, a floor "pays" when the profits from its 
use are a fair return on the capital represented by the cost 
of the floor. If this fair return is figured at ten per cent., 
the ninth floor, costing $160,000, must produce profits 
amounting to $16,000. If the rate of interest is reckoned 
at five per cent., the same $16,000 is a fair return on 
$320,000 — much more than the cost of the floor. Accord- 
ingly, with the lower rate of interest on building capital, 
there would be no reason for stopping with the ninth floor. 
A tenth floor may cost $180,000 and yield a profit of $12,000. 
This sum equals a five per cent, return on $240,000. Another 
story may cost $200,000 and yield a return of $10,000. As 
$10,000 is a five per cent, return on $200,000, this story just 
pays. 

Given a building already completed, no extension of 
business through increase in floor space is usually prac- 
ticable. But the business is not therefore altogether pre- 
vented from expanding. Wide aisles and relatively few 
counters may give way to narrow aisles and numerous 
counters. A small number of salesmen may be replaced by 
a large number. It is not necessary to follow out in detail 
the effect of thus increasing expenses for salaries and for 
capital invested in counters and in stock. The first $100,000 



INTRODUCTORY ECONOMICS 89 

Spent in thus expanding the business may pay very well; a 
second $100,000 may also pay; but it will hardly yield pro- 
portionate returns; after a time the floor space is so well 
utilized that an additional $100,000 expended in this way 
will not bring a fair return. 

Just as in agriculture we found that the rate at which 
returns diminish varies for different crops, so in mercantile 
establishments with limited floor space the rate at which 
returns diminish varies for different lines of trade. Let us 
compare, in this respect, a tinware and a jewelry business. 
If the merchant dealing in tinware should double his stock, 
it is probable that he would crowd his store too much for 
convenience; but the increased business might make this 
profitable. A point would soon be reached, however, where 
further increase in stock would not pay. A jeweler, on the 
other hand, might double his stock, increase it three-fold, 
four-fold — perhaps ten-fold — without serious crowding of 
space. 

We may now go over into other fields, to find other 
manifestations of the law of diminishing returns. In a cer- 
tain city a street railway company, let us assume, has ex- 
tended its lines of track through all the streets which promise 
any considerable traflic. The trackage is then a fixed ele- 
ment in the company's business, analogous with the land of 
the farmer or the floor space of the merchant. The variable 
elements are labor, fuel for power, and auxiliary capital in 
the shape of cars. We may assume — although not strictly 
in accord with the facts — that the cost of running a car is 
just the same whether one hundred cars are operated or one 
thousand. The cost of running one car we will place arbi- 
trarily at $2 a trip.' 

With one hundred cars in the entire system, running at 
intervals of twenty minutes, the company may carry an 
average of one hundred passengers per car per trip, thus 
earning $5 at a cost of $2. It is easy to see that the number 
of passengers carried would be increased if the service were 



go INTRODUCTORY ECONOMICS 

more frequent. Persons who have only a short distance to 
go will form the habit of walking, if the alternative usually 
means waiting fifteen or twenty minutes for an overcrowded 
car. Quite possibly the company would get twice as many 
fares with two hundred cars, running at intervals of ten 
minutes. The second hundred cars therefore would pay a 
handsome profit above the cost of operating them. 

Imagine now that the company places a third hundred 
cars upon its lines, still further reducing the intervals be- 
tween cars. In large measure these cars will simply carry 
passengers who would have been carried by the other cars ; 
and this is of course no gain to the company. The greater 
efficiency of the system, and the greater comfort of riding in 
cars that are never overcrowded, will develop some increase 
in traffic. Possibly this increase will amount to fifty passen- 
gers for each of the new cars. This would mean, according 
to our assumed cost per trip, a gain of $2.50 at a cost of $2. 
An additional hundred cars may increase the number of pas- 
sengers carried by an average of twenty-five for each addi- 
tional car. This would represent $1.25 receipts for every $2 
outlay, and would therefore be uneconomical. 

Of course if costs of operation should diminish or if the 
number of potential passengers should increase, the service 
might profitably be improved still further. 

The manufacturer, of one of our earlier examples, who 
erects a mill to utilize the power obtained by damming a 
stream, is limited in his operations by the power repre- 
sented by the head of water. This is the fundamental limit- 
ing element in his calculations. But it is not to be supposed 
that the power which he will actually obtain is a definite 
quantity. Human ingenuity has devised no means whereby 
all the power actually resident in any natural source may be 
transmuted into a form which lends itself to use. All our 
devices for securing and transmitting power are imperfect, 
the best of them being only less wasteful of energy than the 
worst. Our manufacturer may install a mechanism which 



INTRODUCTORY ECONOMICS QI 

Costs little but permits a large part of the power to go to 
waste. Or he may install a more complicated and costly set 
of devices, which will come far nearer turning to account 
the whole power represented by the fall. We may then 
think of the manufacturer as weighing the advantages of 
different kinds of power plant. The expenditure of $i,ooo 
will permit the utilization of, perhaps, one-half of the power. 
A second $i,ooo may make it possible to utilize two-thirds 
of the power. With a plant costing $3,000 perhaps three- 
fourths of the total power will be utilized. A $4,000 plant 
may utilize four-fifths of the power, and so on. At what 
point will it be more profitable to let power go to waste 
than to incur additional expense to save it ? One-half of the 
power may have a value of $300 per year. Interest and 
depreciation on the $1,000 necessary to obtain this power 
may amount to $150. The value of the power which would 
be obtained through the $2,000 plant, on the basis we have 
assumed, would be $400 ; and the cost, figuring interest and 
depreciation as before, would be $300. The simple plant 
therefore would yield a net value of $150 above cost; while 
the more complicated plant would yield only $100. It would 
accordingly pay best to install the $1,000 plant. If the 
value of the power should double, however, the cost of the 
several kinds of power installations remaining unchanged, 
the $1,000 plant would yield a value of $600 at a cost of 
$150, leaving a net gain of $450; while the $2,000 plant 
would give a power worth $800 at a cost of $300, leaving a 
net gain of $500. The $3,000 plant would yield a power 
worth $900, but at a cost of $450. The net gain is evidently 
diminished through the installation of the $3,000 plant. The 
$2,000 plant is, under the circumstances, the most economi- 
cal available. It is easy to calculate that were the value of 
the power again doubled, the $3,000 plant would yield the 
highest surplus above cost, and so would be the most ad- 
vantageous economically. 

Under present conditions it is an excellent steam engine 



92 INTRODUCTORY ECONOMICS 

which transforms into mechanical power one-sixth of the 
energy of the coal which it consumes. A simple and inex- 
pensive type of engine does not do nearly so well as this. At 
a given place and time, will it be more economical to employ 
an engine of the very highest type, and which naturally is 
very costly, or an inexpensive engine of a simple type ? The 
former may transform into power fifteen per cent, of the 
energy latent in the coal ; the latter, only five per cent. If the 
additional power obtained through the better engine does not 
equal the excess of interest and depreciation charge on the 
more costly engine, the simpler engine is the more economi- 
cal in spite of its wastefulness, from the mechanical point 
of view. 

The element in production which operates to limit the 
expansion of a given business may be capital in its general 
form, not any particular form of capital, as a given amount 
of land, a waterfall, a railway track. It is a fortunate busi- 
ness man who finds his capital limited only by the possi- 
bilities of profitable employment which he commands. In 
practical life a man can secure for use in his business, be- 
sides his own capital, only the additional capital for which he 
can give security. And this is usually limited to some pro- 
portion of the value of his own property. 

Assuming that a manufacturer possesses a capital of 
$50,000, and can borrow $50,000 more, the sum $100,000 
limits his operations as narrowly as any other fixed element 
in his production could do. He has, of course, many 
choices as to the exact disposition of the capital. If he is 
engaged in cotton manufacture, he may use first-class 
machinery, or he may employ a poor grade of machines — 
perhaps machines that have been discarded in other sections, 
as was for a long time a common practice in the South. 
Perhaps he will decide upon investing $50,000 of his capital 
in looms, the remainder being invested partly in the building 
and partly in materials, etc. With twenty-five laborers and 
high-grade looms, the output per laborer will be high ; with 



INTRODUCTORY ECONOMICS 93 

fifty laborers and lower grade looms, the output per laborer 
will probably be less, although the total output of the mill 
will be increased. A third force of twenty-five laborers 
with a still cheaper grade of looms will add something to the 
total output, but the output per man will be still further di- 
minished. Perhaps the output per man, when twenty-five 
are employed, will be $2,000, while wages, cost of material, 
wear and tear, etc., amount to $1,600 per man, leaving a 
total net return of $10,000. With cheaper looms and fifty 
men, the output per man may be $1,900, the cost remaining 
$1,600. This would leave a net return of $15,000, and 
hence would be advantageous. Seventy-five men, with the 
capital put into appropriate form, might produce $1,800 per 
man at the cost of $1,600 as before; and this also would 
represent a return of $15,000. One hundred men, with a 
return per man of $1,700, would yield only $10,000 net. Ac- 
cordingly the most advantageous form in which to put the 
capital devoted to looms must be such as to employ between 
fifty and seventy-five men. If wages were less, a still 
cheaper loom would be the most advantageous. If in the 
examples given, labor and other costs had been $1,000 in- 
stead of $1,600, the net return from the mill equipped with 
the most expensive machinery would have been $25,000 ; the 
return from the mill with the next lower grade, $45,000; 
the next lower grade, $60,000; the next lower, $70,000. If 
we assume that with one hundred and twenty-five men the 
product per man would sink to $1,600, such an arrangement 
of capital as would employ one hundred and twenty-five men 
would yield $75,000 ne<t. With one hundred and fifty men 
and a product of $1,500 each, the net return would be again 
$75,000. Any further increase in the number of men would 
sink the net return below $75,000, and would therefore be 
uneconomical. 

One further instance of the law of diminishing returns 
may be presented here. A farmer and his sons, having 
abundant means, migrate to the Canadian Northwest and 



94 INTRODUCTORY ECONOMICS 

purchase six thousand acres of fertile land. But as land is to 
be had by bona fide settlers at very attractive rates, it would 
be difficult for the immigrating farmer to secure the services 
of hired laborers, even at very high wages, as every able- 
bodied man in the vicinity will wish to acquire land of his 
own by residence thereon. The inelastic element in our 
farmer's enterprise will, therefore, be labor. He will have to 
rely mainly on himself and on his own family for this 
element. 

Under the circumstances, how much of the tract will be 
placed under cultivation? The farmer and his family may 
represent five able-bodied men. With steam plow and steam 
harvesting machinery it would be an easy matter, perhaps, 
for the family to place five hundred acres under cultivation. 
This area might yield ten thousand bushels of wheat. To 
place an additional five hundred acres under cultivation 
would perhaps be possible. With the larger field the plow- 
ing and the harvesting would extend over longer periods, 
and no doubt some of the crop would be lost. The total yield 
might, nevertheless, be fifteen thousand bushels. If an at- 
tempt were made to cultivate a third five hundred acres, very 
likely the work would be done so hurriedly and so much 
waste would be entailed, that the total yield would be only 
fourteen thousand bushels. The most profitable area to be 
cultivated by the working force of five men would therefore 
lie somewhere between one thousand and one thousand five 
hundred acres — far short of the entire tillable area pur- 
chased. 

We may now state the law of diminishing returns in its 
general form. When any one of the several factors whose 
cooperation is essential to production is limited in quantity, 
either absolutely, or by conditions of increasing cost, while 
the quantity of the other factors may be increased practically 
without limit, every unit of increase in the variable factors 
results in an increase of output less than proportionate with 
the increase in the variable factors. 



INTRODUCTORY ECONOMICS 95 

The mere fact that an additional unit of one of the 
variable elements yields a return less than that yielded by an 
earlier unit is no reason why the unit should not be em- 
ployed. It may yield more than it costs, and therefore its 
employment is advantageous to the enterpriser. The product 
of a field with one laborer may be $i,ooo, while the product 
of the same field with two laborers employed would be 
$1,300. The gross gain to the enterpriser from the employ- 
ment of the first workman is $i,ooo, while that from the 
employment of the second is only $300. Yet if wages are 
less than $300 per man, the employment of the second man 
pays. As a general rule, the enterpriser will increase the 
variable factors in his employ as long as the increase in 
gross product resulting from the employment of an addi- 
tional unit exceeds the cost of that unit. 

The examples that have been given have all been drawn 
from the experience of the individual enterpriser. If we 
look at industrial society as a whole, we observe that the 
law of diminishing returns has a still wider application. 
Labor and capital may be thought of as the two factors 
cooperating in producing a vast mass of commodities — ^the 
social income. If one of the two factors remains fixed in 
amount, while the other factor increases, the aggregate 
product of society will increase, but not in proportion to the 
increase in the varying factor. As in a single enterprise, the 
product increases in proportion to the increase of either 
factor only when the other factor increases concurrently and 
in practically the same proportion. 

One apparent qualification must be made at this point. 
Improvements in methods of production are constantly tak- 
ing place, with the result that a given amount of labor or of 
capital increases in efftciency. If the amount of labor em- 
ployed upon a hundred-acre field increases, the increase in 
product will not ordinarily be proportionate to the increase 
in labor. But if at the same time a new way of cultivating or 
fertilizing the soil should be discovered^ or if the quality of 



9^ INTRODUCTORY ECONOMICS 

the seed should be improved, the product might very well 
increase relatively to the amount of labor. This fact does 
not prove that the law of diminishing returns is non-existent. 
It merely proves that there are other forces at work which 
may, at times, neutralize its effects. These forces are of 
course of the greatest practical importance, and will later 
demand our attention. 

A more important qualification of the principle of 
diminishing returns consists in the fact that the very process 
of increasing the number of units of variable factors em- 
ployed in connection with an unvarying factor may, under 
certain circumstances, increase the productive efficiency of 
each unit of the varying factors. To employ two men on an 
acre of land that could be cultivated by one would result in 
a diminished return per man if each worked alone. But 
many tasks may be better performed when two or more 
men cooperate than when each works by himself. Accord- 
ingly, it may happen that an increase in labor which makes 
cooperation possible, or an increase in capital which makes 
possible better methods, may be accompanied by increasing, 
instead of diminishing returns. 



CHAPTER VII 
The Division of Labor 

In a frontier community, where almost the entire popu- 
lation consists of independent families living upon farms, the 
economic functions performed by each person are numerous 
and diverse. The frontiersman must, in the first place, be 
an agriculturist and a grazier. Each of these occupations 
includes numerous functions calling for different qualities, 
the agriculturist being a plowman, sower, reaper, etc. The 
frontiersman must also be a woodcutter at times, a car- 
penter, a mason, a cabinet-maker, a smith, a butcher, and a 
hunter, not to speak of a host of miscellaneous functions 
that he must occasionally perform. His wife probably has 
a no less varied array of occupations. She is a cook, a 
laundress, a sempstress, a dairymaid, a spinner, a weaver, a 
nurse, and a teacher. To survive on the frontier one must 
be a jack of all trades. And practically the same range of 
duties falls upon the strong and the weak, the intelligent and 
the dull, the man who quickly acquires skill and the man 
who acquires it with great difficulty. 

Under such conditions it is natural that every kind of 
work should be performed but indifferently well. The 
house erected by a man who is usually occupied in tillage 
may afford comfortable shelter ; that it will have any great 
degree of convenience or beauty is improbable. The cloth 
woven by the frontiersman's wife will necessarily be coarse 
and lacking in finish. The tillage of the field and the man- 
agement of the household will be conducted less satisfac- 
torily than they would have been if the farmer and his wife 
had not had so many other matters to divert their attention 
and energy. 

Not only will the quality of the work performed under 



98 INTRODUCTORY ECONOMICS 

such conditions be poor, but it will also entail a relatively 
high cost in labor. The frontiersman does not work for a 
sufficient time at any one thing to acquire the "knack" of 
doing it — that is, such a habit of mind and muscle as will 
give the work a semi-automatic character. If he hews 
beams for a house, it will, at first, be only by the greatest 
effort that he will hew true to the line. A great deal of 
time will be lost in smoothing out the irregularities of sur- 
face due to unskillful use of the ax. A second beam is hewn 
with a less expenditure of time and labor than the first; a 
third with still less. But by the time a reasonable degree 
of skill is attained, all the beams are hewn, and there will be 
no further use for the acquired facility in this line for sev- 
eral years, when it will largely have disappeared through 
disuse. 

Another disadvantage under which the frontier economy 
suffers is the waste of time involved in passing from one 
task to another. The frontiersman may want meat, and so 
be compelled to interrupt the labors of the field in order to 
kill. With his low grade of skill as a butcher, this operation 
may take him three-fourths of a day. To return to the field 
for the remaining fraction of the day would hardly seem 
worth while. And so our frontiersman will "potter around," 
trying to find some neglected task about the house or barn, 
which might almost as well never be done, or will decide to 
rest from his labors. 

Of course some families will prosper better under the 
circumstances than others. Some men will excel in one 
function, some in another, and those who excel in the 
functions that happen to be most vital under the conditions 
will have the greatest degree of success. Some will be utter 
failures, wasting so much time turning irresolutely from 
task to task that they accomplish nothing. These same men 
might have proven highly efficient workmen under different 
industrial conditions. If our frontier communities had kept 
detailed records, we should find that they contained many a 



INTRODUCTORY ECONOMICS 99 

man who would have made a good architect or engineer, 
many a woman who would have made an excellent modiste 
or teacher, but who proved hopeless failures in the environ- 
ment in which they were placed. Architecture and engineer- 
ing, designing of costumes and teaching of children, were 
indeed functions not wholly neglected, but they made up a 
very small part in the life of each family and gave little 
opportunity to any one for the full development of his 
natural talents. 

Were the frontier community wholly isolated for many 
generations, a transformation of its industrial organization 
would gradually take place. A person with more than the 
ordinary talent for building would be called upon to assist 
in the construction of his neighbors' houses, receiving in 
return assistance in work for which he had no special quali- 
fication. Little by little, occupations would be differentiated, 
and eventually the community would contain among its 
population carpenters, smiths, masons, weavers, etc. While 
these craftsmen might still own land, and spend their odd 
hours in agriculture, the main source of their livelihood 
would be the exercise of their several crafts. Division of 
labor in its ' simplest form would thus have come into 
existence. 

Whether this division of labor could be carried far or 
not would depend in large measure upon the growth of 
population and wealth in the comm.unity. Good work must 
be appreciated before wages will be offered which are suffi- 
ciently attractive to induce men to devote all their time to 
the crafts. There must be a wide enough demand for such 
labor to keep the craftsman busy most of his time. If a" 
dozen houses are built every year, a carpenter may find 
steady employment; if the community is so small that only 
one or two houses are built yearly, no one can make car- 
penter's wages his chief reliance. The community must be 
of a considerable size before any man can earn his liveli- 
hood as a smith. Weaving carried on as a regular occupa- 

LOFa 



TOO INTRODUCTORY ECONOMICS 

tion likewise presupposes a fairly advanced condition of 
society. 

But, of course, our frontier community would not 
remain thus isolated for generations. Traders would soon 
appear, to carry away the lighter surplus products, giving in 
exchange the manufactured goods of older communities. A 
railroad would, in time, transform the frontier community 
into an integral part of the civilized world. And this might 
retard the progress of division of labor within the community. 
Instead of weaving its own cloth, it would barter its sur- 
plus products of the soil for textiles produced in other parts 
of the world. Many functions, however, would have to be 
performed on the spot, and these would leave occasion for a 
considerable division of labor. 

As the community advanced in numbers and wealth 
one function after another would be taken out of the 
province of the man of all work, and given over to persons 
specially qualified by nature and training to perform it effec- 
tively. Each trade, again, would tend to subdivide. The 
carpenter would no longer plan the building upon which he 
worked, this function being given over to the architect. The 
planing of boards would cease to be a part of the carpenter's 
work, as planing mills would be established which would do 
the work far more economically. Even in agriculture some 
differentiation would take place, one man devoting himself 
chiefly to the growing of grain, another to raising vegetables, 
etc. Owing to the seasonal character of agricultural labor, 
however, and the advantages of combining crops in such a 
way that the work may be distributed as evenly as possible 
throughout the open months, specialization in agriculture 
could not be carried very far. Indeed, even in the best 
developed agriculture, we do not find some farmers specially 
devoted to wheat culture, others growing nothing but corn, 
others potatoes or turnips. Agriculture by its nature pre- 
cludes a high degree of division of labor. 

We may now proceed to a statement of the conditions 



INTRODUCTORY ECONOMICS lOI 

under which division of labor can take place. The first of 
these is the existence in a community of a sufficient demand 
for a particular kind of work to make it possible for a man 
to devote himself almost entirely to that kind of work. It 
has been pointed out that a considerable number of houses 
must be erected every year in order to call into existence the 
carpenter's trade. The local demand for well made clothing 
must be fairly extensive before clothes-making can detach 
itself from the province of the housewife and take the form 
of a separate trade. 

If the demand for well made clothes becomes very 
great, opportunity for still further diJfferentiation, within the 
tailor's trade itself, may arise. One man may devote him- 
self exclusively to the making of overcoats, another to the 
making of coats or waistcoats. The making of a single gar- 
ment may be further split up among different workmen, one 
occupying himself with the fitting of garments, another with 
cutting, while the sewing may be distributed among several 
persons, each doing the work for which he is best fitted. 
Similarly, if the demand for furniture is extensive, one man 
may devote himself entirely to the making of chairs, another 
to the making of desks; or one man may specialize in the 
making of plain articles of ordinary use, while another 
makes only fine pieces. 

Where the producer of a commodity deals directly with 
the consumer, the opportunity for minute division of labor 
is not so great as where the producer is brought into rela- 
tions with the consumer through the intermediation of a 
general market. The amount of work that may be secured 
by a single custom tailor's shop is limited by the number of 
purchasers of custom-made garments within easy distance. 
In a village this number may be so small that anything like 
subdivision of the tailor's trade may be impracticable. In a 
large city the case is different. A single shop may easily 
find customers enough to keep twenty men at work. In the 
latter case division of labor is entirely practicable. If transit 



102 INTRODUCTORY ECONOMICS 

facilities in the large city are excellent, the number of men 
that may be employed by a single tailoring establishment may 
be one hundred or more, and labor may be as minutely sub- 
divided as the employer may desire. In the making of fur- 
niture at the order of the consumer, similar limitations upon 
division of labor are found, the small town being able to 
support only a small shop, where all the work is performed 
by two or three men, while the large city renders possible 
the large shop, with minute subdivision of labor. 

Division of labor finds its highest development where 
the nature of the commodity produced is such as to permit 
the easy assembling of materials in one place and the sale 
of the finished product throughout a wide area. Thus the 
materials for an ordinary grade of cotton cloth may be 
assembled in almost unlimited quantities in a New England 
town, and the finished product may be sent without great 
cost to any part of the world. Division of labor in a cotton 
mxill will be hardly at all subject to limitations of the kind 
that we have discussed. Ordinary grades of furniture may 
likewise be manufactured by one establishment without re- 
gard to limitations of the local market, and the division of la- 
bor in such an establishment may be carried as far as the in- 
herent advantages of the system may urge. The business of 
making ready-made clothing may be cited as another case in 
which the intervention of a general market has made pos- 
sible minute division of labor. How great is the revolution in 
methods that has been brought about by this divorcing of the 
producer from the consumer, through the development of 
the general market, may best be brought home to us by con- 
trasting the methods of the local cobbler, making shoes to 
order, with those of the modern shoe manufacturer, supply- 
ing a world market. The work which the cobbler performs 
in making a shoe is, in the factory, split up into over a hun- 
dred different functions, each being performed by a separate 
set of workmen. 

The contrast between the two systems, that of the small 



INTRODUCTORY ECONOMICS lO^ 

shop with hardly any division of labor, and that of the large 
establishment with labor minutely subdivided, may be seen 
in many industries that are at present in a stage of transition 
from the former system to the latter; and in most cases the 
transition is largely explainable by forces that have ren- 
dered the producer independent of the local consumer. 
Until refrigeration had been reduced to a science, and the 
methods of transporting products preserved by ice had been 
perfected, every locality depended, for its supply of meat, 
upon the local butcher. If the consumers in the vicinity 
were few, they were ordinarily supplied by small shops 
which permitted only a low degree of division of labor. In 
the cities, the shops v/ere larger, and division of labor was 
carried farther. To-day there is almost no limit to the 
market for a single establishment. Fresh mutton killed in 
New Zealand and Australia finds a ready market in England. 
Fresh meats from Chicago may be found in practically any 
city or town in the land. The parallel development of live 
stock transportation has given the slaughtering centers a 
practically unlimited supply of raw material. Accordingly a 
minute division of labor has been evolved in the slaughter 
houses. In the Chicago slaughter houses the killing and 
dressing of a bullock is subdivided into fifty or sixty separate 
functions, each assigned to a separate set of workmen, each 
set making some small change in the material and passing 
it on to another set. Of course some functions are per- 
formed by single workmen, some by several. The laborers- 
are organized in gangs of 230 men, each gang containing 
just the appropriate number of men of each class. 

The extent to which division of labor may be carried 
depends also upon the prevailing form of the economic 
organization. Where each workman is his own employer, as 
was generally the case in the medieval industrial organiza- 
tion, labor cannot be very minutely subdivided. In such an 
industrial organization the spinner buys his wool and sells 
his product to the weaver ; the latter sells the cloth to the 



104 INTRODUCTORY ECONOMICS 

fuller, who, in turn, sells it to the dyer. The product is 
again sold, perhaps, to the shearer, who may in turn sell the 
finished cloth to a draper, who deals directly with the con- 
sumer. With such a form of organization much time is 
necessarily wasted in the buying and selling of the material 
in its several stages, and the greater the number of stages, 
the greater the waste from this source. Again, as each per- 
son follows his own taste in choosing his trade — subject, of 
course, to family tradition and trade restrictions — it is un- 
likely that the society will have just the right number of 
craftsmen of each kind. At one time there will be too many 
spinners, relatively to the num.ber of weavers; at another 
time fullers will be so numerous that not all can be employed. 
And this element of waste also increases with increasing 
subdivision of labor. 

Where, on the other hand, industry is carried on under 
the factory system, the workmen all being assembled under 
one roof, subject to the control of an employer, the material 
passes through the shop without interruption, and appren- 
tices are taken on in each branch in the proportions which 
experience shows to be most desirable. Of course this im- 
plies a large accumulation of wealth on the part of the 
employer, who must provide the premises, furnish materials, 
pay wages, and assume all other expenses of production. In 
fact, we may say that large capital and efficient management 
are prerequisites to a thoroughgoing system of division of 
labor. And, of course, efficient management on the part of 
the employer implies a corresponding readiness to submit to 
direction on the part of the employee. We might easily con- 
ceive of a society in which all other conditions requisite to 
division of labor might exist, but in which division of labor 
of an advanced type would, nevertheless, be impracticable 
on account of the restlessness of the working population 
under close direction. 

The fact that division of labor is so generally employed 
wherever the conditions are ripe for it is a sufficient indica- 



INTRODUCTORY ECONOMICS 105 

tion that the system must offer important economic advan- 
tages. To enumerate all these advantages would require 
a volume; but we may group the more important ones 
under a few heads. In the first place, the limitation of 
the labor to be performed by one man to a single func- 
tion, which involves the use of a single tool, and which 
may be reduced to a few simple movements, makes 
possible accurate workmanship and great speed, with rela- 
tively little weariness. The workman soon reduces his 
movements to a rhythm ; he grasps each piece of material in 
the same way, delivering his blows upon it in such a way as 
never to throw away his energy. Every one knows how 
much better results a trained oarsman secures from the 
expenditure of a given amount of muscular energy than the 
raw beginner, who puts forth his strength now on the water, 
now on the air, now in the right direction, now in the wrong 
one. The difference in effectiveness between the strokes 
delivered by the man who works with a single tool, and the 
strokes delivered by one who works with a dozen tools, is 
hardly exaggerated by the comparison. 

The best workman loses some time in changing from 
tool to tool. It is not difficult to find a carpenter who spends 
many fruitless moments searching now for his saw, now for 
his hammer, while the whereabouts of the plane or square, 
when these implements are needed, proves a baffling, if not 
insoluble problem. And this is the man who leaves his work 
with the loudest complaints of his weariness. A division of 
labor that holds a man so strictly to business that he never has 
any chance to stop to search for anything, obviously con- 
tributes materially to reduce such waste of time and energy. 

Division of labor makes it possible for persons who 
have not the time or the versatility to learn how to perform 
a variety of functions to attain to a place of usefulness in 
industry. There are many persons who have not the time 
to learn the tailor's trade; many who have the time for 
apprenticeship, but not the general ability required for the 



I06 INTRODUCTORY ECONOMICS 

making of a well-fitting coat. Few persons are so stupid 
that they cannot, with slight waste of time, learn how to sew 
a straight seam. If the work of making a coat is distributed 
among a dozen persons, each one can quickly learn to do his 
particular part well. Further, in the distribution of the 
work, each one may be given a task proportioned to his 
■ability. The skilled cutter will not waste his time picking 
basting threads, and the person for whom the latter function 
is a sufficient profession, will be kept from spoiling material 
through attempting something more ambitious. 

The simplification of the task of each laborer makes it a 
comparatively easy matter to ascertain how much any par- 
ticular one is actually getting done. One who has lived in 
the country has probably made the acquaintance of two 
types of laborers: the first, those who are always bustling 
about in a hurry and yet accomplishing little; the second, 
never in a hurry, yet showing, in the end, a good record of 
achievement. Because of the miscellaneous character of the 
work of the agricultural laborer, it takes a long time to 
measure the relative efficiency of different men. Where a 
man is compelled to repeat the same operation throughout 
the day, no show of bustling energy will create the illusion 
of achievement. The pieces of work done have simply to be 
counted, to give an accurate idea of the laborer's efficiency. 
It is obvious, then, that the difficulty of supervision is 
greatly reduced by systematic division of labor. 

Perhaps the greatest advantage that arises from division 
of labor is the stimulus it gives to the invention of labor- 
saving machinery. A hundred years ago it would have 
seemed quite impossible to manufacture shoes largely by 
machinery. The process of manufacture appeared so com- 
plicated that hand labor alone would answer. To-day shoes 
are largely the product of machines. Many forces cooper- 
ated, of course, to bring about this result, but only one of 
these concerns us here, the division of labor. When a com- 
plicated operation like the making of a shoe is split up into 



INTRODUCTORY ECONOMICS IO7 

several score of simpler operations, some of these are likely 
to prove so nearly mechanical that the idea of machines to 
take over the work suggests itself. If the process of pro- 
duction is divided into twenty-five parts, perhaps the third, 
and eleventh, and seventeenth are taken over by machines. 
In time division of labor still further simplifies the remain- 
ing operations ; additional ones prove themselves to be fitted 
for machine work, and thus more of the hand-workers are 
displaced. It is conceivable that in the end practically the 
whole process might be taken over by machines, the hand- 
worker' being transformed into an attendant of the machine, 
so to speak, feeding it with material, and passing on the 
product to another machine. 

We may now consider how far the principle of division 
of labor modifies the operation of the principle of diminish- 
ing returns, described in the last chapter. According to that 
principle, an increase in the amount of labor employed in 
connection with a limited amount of capital gives a return 
which is not proportionate with the increase in labor. But 
what if the additional laborers give opportunity for division 
of labor which had not before existed? Suppose that a 
tailor's shop with a capital of $20,000 formerly employed 
six men ; it now employs twelve men. Division of labor can 
be carried farther with twelve men; hence is it not pos- 
sible that the employment of the second six men will double 
the output of the shop? This is quite possible. An addi- 
tional six men will give occasion to more systematic division 
of labor, and so many still further increase the efficiency of 
each man. And so with a fourth set of six men. But it is 
evident that one cannot go on indefinitely subdividing the 
work of making a coat. Eventually a point will be reached 
where further subdivision of labor increases the efficiency of 
each laborer only slightly ; still further subdivision, even less ; 
finally a degree of subdivision will be found that will not 
pay. That is, the principle of division of labor is itself sub- 
ject to diminishing returns. A practical proof of this fact is 



I08 INTRODUCTORY ECONOMICS 

to be found in the organization of the working force in many 
large estabhshments where much use is made of division of 
labor. The making of a complete article is not assigned to a 
single man; nor is it assigned to all the men in the shop, 
each contributing a trifling modification to the material. 
Each article is assigned to a "team," among the members of 
which the successive manipulations of the material are dis- 
tributed. The entire working force may contain scores of 
teams. Now the size of each team indicates the limits upon 
profitable division of labor. If an enterpriser limits each 
team to sixty men, this is proof that in his opinion a team of 
seventy men would not show so large a product per man. 

We may grant that an increase in laborers employed in 
connection with a given capital may possibly result in an 
increase in product more than proportionate with the in- 
crease in labor. This may hold true until the number of 
laborers is sufficient to compose a team of maximum effi- 
ciency. If an additional team is engaged, without increase 
in capital, it is doubtful that returns will increase in propor- 
tion to the number of teams ; a third team will show a return 
less than that of the second, and so on until the point is 
reached where it does not pay to employ an additional team. 
So far as the principle of division of labor is concerned, 
then, the only qualification to be made in the law of diminish- 
ing returns is that when we assume that labor increases, we 
must assume that it increases by teams, not by individual 
men. 



CHAPTER VIII 
The Concentration of Industry 

It is a matter of common observation that it requires a 
larger capital to launch a business to-day than was required 
twenty years ago; and most men believe that twenty years 
hence a still larger capital will be required to give an estab- 
lishment a fair start. This tendency toward ever larger 
establishments is what is commonly known as concentration 
of industry, or industrial concentration. 

At the outset, the fact must be noticed that not all 
branches of business are equally affected by the tendency 
toward industrial concentration; and that even in the 
branches that show the best instances of this development, 
many establishments are checked in their growth by the dif- 
ficulties they experience in extending their control over cer- 
tain of the essential factors of production. In agriculture, 
for example, there is little evidence of any such tendency. 
In that industry, an important element in success consists in 
keeping the dwelling place of the laborers so near to the 
fields that no great amount of time is wasted in going to and 
from the work. It is also essential that the barns and 
granaries be near enough to the fields to obviate excessively 
long haulage of the products. It follows, then, that the 
number of acres that may be managed from a common cen- 
ter is somewhat narrowly limited. An apparent exception 
to this rule is to be found in the great wheat farms of Cali- 
fornia, the Dakotas and the Canadian Northwest. Here the 
land is level and free from stones and stumps of trees ; the 
natural fertility is great, and evenly distributed over large 
areas. Cultivation consists simply in plowing, sowing and 
harvesting ; and this can be done by aid of the highest type 
of agricultural machinery. As soon as the natural fertility 



no INTRODUCTORY ECONOMICS 

of the soil is exhausted, however, a more intensive tillage 
will be necessary; fertilizers will have to be applied; rota- 
tion of crops will succeed continuous wheat-cropping. For 
such tillage the immense unbroken fields are not well 
adapted. The "bonanza" farm is a transient as well as an 
exceptional phenomenon. 

In many sections of the country the making of bricks 
remains in the hands of small enterprisers. Common bricks 
are so bulky a commodity that they cannot be transported 
long distances without paying an excessively high charge for 
freight — unless made in a locality specially favored by water 
or cheap railway transportation. The size of a brick-making 
establishment, then, must ordinarily be gauged by the de- 
mand for bricks within a reasonable radius of the kilns ; and 
if this demand is not a growing one, there cannot appear a 
tendency toward larger brick-making establishments. 

Somewhat analogous is the case of the local merchant. 
Those persons living within a reasonable distance of his 
store can be reached by his order clerks and delivery 
wagons. Beyond this distance, however, it will not pay to 
solicit orders. If the population within the radius of profit- 
able business is large, of course the store may be large. If 
the region is sparsely settled, the store must be small. 

Instances of businesses thus limited by external circum- 
stances might be multiplied. We may say, in general, that 
such limitations arise wherever either materials of produc- 
tion or the finished product must be conveyed increasing dis- 
tances, with rapidly increasing cost, whenever an establish- 
ment enlarges its business. Of course anything that reduces 
cost of conveyance materially enlarges the area within which 
a given business is confined. The advent of the gasoline 
motor delivery wagon has enabled some village "general 
stores" to develop into more ambitious "department stores." 

Again, when a business is once established, it may not 
admit of any great degree of expansion, even if market 
conditions are favorable. A shoe factory, for example, may 



INTRODUCTORY ECONOMICS III 

find a practically unlimited demand for its products at 
remunerative prices. By a rearrangement of its machinery, 
and the employment of additional laborers, it may some- 
what enlarge its output; but, as we saw in Chapter VI, this 
process cannot long continue without calling into operation 
the law of diminishing returns. A new factory may be 
established alongside the old one; but the advantages to be 
gained from such duplication of plant are inconsiderable as 
compared with the advantages that would have arisen could 
the old factory have been completely remodeled on a larger 
scale. 

The advantages to be gained through industrial con- 
centration are best brought to view by an examination of the 
considerations that determine the size of a new establishment 
in an industry which is only slightly dependent upon local 
conditions of supply of material and consumption of product. 
Such independence of local market conditions is most com- 
monly met with in industries which work up materials that 
can easily be assembled in large quantities, and the products 
of which are of such a nature that they can bear the ex- 
pense of transportation to distant markets. The textile and 
the iron and steel industries may be regarded as typical of 
the branches of production giving the best opportunity for 
industrial concentration. 

Let us imagine that we are present at the launching of 
a new enterprise in one of these branches of business. What 
will be the size of establishment determined upon? Of 
course a first consideration must be what amount of capital 
can be raised. If, however, it is generally believed that with 
a capital of $500,000 an establishment in a given industry 
can prosper, while one with a capital of $100,000 would with 
difficulty survive, it is likely that an enterpriser proposing 
to start the larger business will find less difficulty in raising 
the capital than would an enterpriser proposing to found a 
$100,000 business. The real determinant of the size of a new 
establishment, then, will be, not the financial consideration 



112 INTRODUCTORY ECONOMICS 

as to the amount of capital that can be raised, but the tech- 
nical consideration as to how much capital is necessary for 
success. If this amount cannot be raised the project is 
dropped. 

As we saw in the last chapter, manifold advantages 
spring from the division of labor. The establishment to be 
launched must be at least large enough to make the fullest 
practicable use of this principle. Perhaps this end would be 
attained, so far as the working force directly engaged in the 
process of manufacture is concerned, in an establishment 
with a capital of $100,000 and with 100 laborers. A second 
100 laborers, supplied with an equal amount of capital, might 
double the output, but they would not increase the efficiency 
of the first hundred men. So with a third and fourth hun- 
dred men. No further economy in concentration arises un- 
der this head. 

In addition to its manual laborers, the establishment 
must have an "office" force; possibly it may have buying 
agents, who travel long distances in search of the various 
materials, and selling agents, likewise compelled to travel 
about in search of buyers. A small establishment could sup- 
port only a small number of employees of these classes ; 
there could be no extended division of labor among them. 
An establishment of larger size might be able to assign one 
man exclusively to the purchase of one kind of material, an- 
other to the purchase of another kind, and so enjoy the ad- 
vantages of specialized skill. Similar division of labor might 
be effected among the selling agents and among the mem- 
bers of the office force. In this way a very large establish- 
ment could assure itself that every commercial situation aris- 
ing would receive expert attention. There is, of course, no 
theoretical limit to the possible gains from this source. An 
establishment might be so large that it could have a man 
devoting his full time to the purchase of machine oil for its 
use, and something would doubtless be gained through the 
skill he would develop. But in practical life such trifling 



INTRODUCTORY ECONOMICS 1 13 

gains would have little effect in determining the size of an 
establishment. They are too small to make a perceptible 
addition to dividends. 

The process of manufacture may involve a score or 
more of manipulations of the material, and at each stage sev- 
eral machines may be drawn into use. A number of differ- 
ent types of machinery are on the market, some performing 
the function required with greater celerity and certainty than 
others, the better machines, naturally, representing a larger 
investment. To equip a factory throughout with the best 
machinery would require a large capital, even if the process 
could be reduced to a series of steps occupying one set of 
machines as long as another. Such a division of the process 
is not ordinarily practicable ; some machines contribute only 
very slight changes in the material, delaying it but a mo- 
ment as it passes through, while other machines subject the 
material to rnore important changes and delay it for a longer 
period. In order that the machines may all be used to their 
full capacity, there must be a number of machines engaged 
in the slower parts of the process to one engaged in the part 
which can be performed quickly. And this involves a still 
further increase in the capital of the establishment. 

The providing of power, in most manufacturing indus- 
tries, is one of the most important of technical problems, 
and here the large establishment usually has decided advan- 
tages. The larger the power plant, in general, the cheaper 
can power be furnished. There is not so much heat wasted 
in a large furnace as in a small one; a large power plant 
can be so arranged as to prevent much of the waste of power 
in transmission that usually takes place in a small establish- 
ment. Here it would be difficult to find a theoretical limit 
to the advantages that follow from an increase in size of 
plant. In practice, however, the economies to be gained in 
this way are not very important after a moderate size of 
plant has been reached. We do not find men constructing 
huge factories merely to obtain the advantages of cheaper 



114 INTRODUCTORY ECONOMICS 

power, although these advantages may not be entirely neg- 
lected in determining upon the size of a business to be 
estabHshed. 

In most industries, the general progress of invention is 
in the direction of more and more costly machines, and this 
is one of the more important reasons for the trend toward 
industrial concentration. At a particular time, however, 
there is a theoretical size of business which permits full 
equipment with the best machines then available. An in- 
crease in the establishment beyond this point brings no ad- 
vantage in the direct process of manufacture. There may, 
however, be other important advantages to be gained 
through such enlargement of plant. 

In almost every industry the material undergoes some 
shrinkage in the process of manufacture, through the re- 
moval of parts not fitted to enter into the main product. 
These parts are waste in a small establishment, and the 
problem of getting rid of them is often a serious one. In 
the large establishment they accumulate in enormous quanti- 
ties, and the question whether they could not be utilized in 
some way readily suggests itself. Through successive ex- 
periments, one element after another ceases to figure as 
waste, being transformed instead into a ''by-product." Thus 
forty years ago much of the residue of the small oil refineries 
was allowed to flow away in the streams. The same material 
to-day is the basis of scores of by-products, the value of 
which is an important element in the profits of the petroleum 
industry. Compare the methods of waste disposal of the 
small butcher shops of to-day with those of the great pack- 
ing houses. To the former from forty to sixty j)er cent, of 
every animal slaughtered is sheer waste, to be got rid of in 
whatever way the public health authorities will permit. This 
waste in the large establishment is transformed into over a 
hundred by-products, practically no part of it being consid- 
ered wholly valueless. Such utilization of waste requires 
the investment of a considerable capital in various kinds of 



INTRODUCTORY ECONOMICS Il5 

plant and the employment of a large body of laborers who 
have nothing to do with the main product. Some of the 
by-products take from the mass of waste only insignificant 
elements ; hence their utilization is possible only when waste 
accumulates in enormous quantities. It is obvious that only 
a very large establishment can carry on a thoroughly sys- 
tematic plan of developing by-products. An establishment 
large enough to enjoy all the advantages of division of labor 
and of costly machinery may not be one-tenth large enough 
to gain all the profits of waste utiHzation. 

It has already been pointed out that an important ad- 
vantage of the large establishment is the possibility of or- 
ganizing its buying and selling agents in such a way as to 
develop special skill for each kind of transaction. A further 
commercial advantage consists in the fact that purchases 
can be made on a large scale, and therefore, generally, on 
especially favorable terms. The dealer in raw material can 
afford to sell at an unusually low price to a customer whose 
purchases may mount up into millions. The same thing is 
true of all other dealers who supply the large establishment. 
There may, indeed, be a combination among such dealers, 
fixing the margin of profit at which each must sell ; but such 
a combination can do little toward extorting high profits 
from an enterpriser who can, if he chooses, dispense with 
the middlemen altogether, and deal directly with the pro- 
ducer of the materials. The maker of machinery is likewise 
compelled to content himself with a small profit when deal- 
ing with a concern which has capital and enterprise enough 
to make its own machinery, if it finds a profit in so doing. 
In its sales, it enjoys similar advantages. It can provide any 
purchaser v/ith such quantities and such qualities as he may 
desire. If part of the product is to be exported, the large 
establishment can afford to send agents to foreign countries 
to find out what qualities are desired, and in what form the 
product will be most acceptable to the foreign taste. 

The large enterpriser, further, can make a more sys- 



Il6 INTRODUCTORY ECONOMICS 

tematic study of the market than can the smaller one, and so 
can make his purchases and sales when the markets are most 
favorable. Moreover, the products of the large establish- 
ment are usually transported more cheaply than those of the 
smaller estabHshment. Practically all supplies, even those 
that form a relatively insignificant part of the total pur- 
chases, can be taken in carload lots ; the more important sup- 
plies in train loads, peirhaps. Where the transportation 
companies are not prohibited by law from making excessive 
reductions in favor of the large shipper, the latter can often 
force the transportation company to discriminate heavily in 
his favor, under threat of giving the entire business to a rival 
company. And even where the transportation company is 
required by law to treat all its patrons alike, the large estab- 
lishment is likely to get special favors from the company, un- 
der one pretext or another. In sea transportation, the large 
company may build ships of its own, especially adapted to 
its needs, if ship owners are not ready to make suitable 
concessions. 

No matter how large the capital of an enterprise may 
be, there will at times be need of borrowing money. At a 
particular time the market for materials may be so favorable 
that it will be profitable to purchase large supplies beyond 
current needs. An active business will not have on hand 
any large amount of idle cash; hence the necessity for bor- 
rowing. As a rule bankers lend money at a lower interest 
rate to a large enterpriser than to a small one. The principal 
reason why they do this is that the large establishment ap- 
pears to offer better security than the small one. 

The foregoing is of course very far from an exhaustive 
statement of the advantages of the large enterprise as com- 
pared with the small one. Other advantages will readily 
occur to any one who observes the economic development of 
the locality in which he lives. It will be observed that 
some of the advantages are prominent in one industry, some 
in another. In the manufacture of cotton cloth, for example, 



INTRODUCTORY ECONOMICS Il7 

there are no important by-products to be utilized. The mar- 
ket for ordinary grades of cloth is well developed; the job- 
ber takes the product from the manufacturer's hands and 
disposes of it to the retailer, charging a commission so low 
that it would hardly pay the manufacturer to develop selling 
agencies of his own. Neither the material nor the product 
is very bulky, in comparison with its value; hence the ad- 
vantages enjoyed by the large concern in the matter of freight 
transportation are not likely to be of very great importance. 
To equip a mill thoroughly with the best machinery in the 
market does not require a very enormous capital; nor does 
an establishment have to be very large to enjoy to the full 
the advantages of division of labor. Certain advantages do 
indeed attend mere size, even in this industry ; but they are 
not so important that they may not be counterbalanced by 
slightly better management on the part of the smaller 
establishment. 

In the iron and steel industries, on the other hand, a 
complete equipment of machinery is usually very costly, re- 
quiring a large capital to keep every important machine in 
constant use. The transportation of materials and products 
is expensive, and a great part of the profit of an establish- 
ment may depend upon the kind of contract that can be made 
with the transportation companies. By-products are not very 
important, but the larger establishment can secure large 
economies through making the best use of its material. Fuel 
is of course an immensely important item in the industry, 
and decided advantages are to be obtained through purchases 
on a large scale. Furthermore, the larger the establishment 
the greater the economy possible in the use of the fuel. Ac- 
cordingly, in this industry a very large plant will have sub- 
stantial advantages over one of moderate size. In the meat 
packing industry, so far as the use of machinery is con- 
cerned, there is no important advantage enjoyed by the 
very large plant of which a plant of moderate size could 
not avail itself. Economy of fuel is another minor con- 



Il8 INTRODUCTORY ECONOMICS 

sideration in this industry. The important advantages of 
the large plant consist in better division of labor, better 
utilization of by-products, better conditions of transporta- 
tion, and more effective advertising. In the refining of 
petroleum almost every form of advantage that has been 
mentioned favors the large establishment. 

It is not to be inferred that the advantages of the large 
establishment are confined to manufacturing industry. Mer- 
cantile business shows much the same tendency toward con- 
centration. In the retail trade, the large establishment en- 
joys great advantages in the purchase and sale of goods ; it 
not only buys more cheaply, but it is better able to cater to 
the tastes of its customers than the small store. It can 
afiford a style of advertising that reaches the public, while 
the small establishment is likely to throw away the money 
it spends in advertising, not succeeding in imposing the con- 
viction of its merits upon the prospective customer. 

Theoretically it is difficult to establish a point beyond 
which further enlargement of a business establishment would 
be unprofitable. Every enlargement of a petroleum refin- 
ery, for example, makes possible some new economies. After 
a certain size has been reached, however, an establishment is 
able to enjoy most of the known advantages of large scale 
production. In some industries this involves an investment 
of $500,000 ; in other industries, perhaps, of $50,000,000. 
A capital of such size the enterpriser will vigorously strive 
to bring together. A profitable business may perhaps be 
conducted with a much smaller capital ; but it will be more 
and more seriously handicapped as time passes, and the 
average size of new competing establishments increases. 

There is of course no reason why an establishment 
should not be much larger than is necessary to obtain prac- 
tically all the benefits of large scale production known at the 
time. Say that a $2,000,000 plant offers all these advantages, 
there is no reason why a $4,000,000 or a $6,000,000 plant 
should not be established. But capital cannot be got to- 
gether without effort ; and unless substantial advantages are 



INTRODUCTORY ECONOMICS llQ 

to be gained through the larger investment, the enterpriser 
is likely to rest content with the smaller one. 

As we have seen, the expansion of businesses already 
established, in whatever branch of industry, is confined to 
narrow limits by the law of diminishing returns. There is 
a similar law which confines within narrow limits the size of 
a new enterprise in an industry dependent upon local sup- 
plies of material, or a local market for its products. With 
such enterprises, a point is reached where increasing busi- 
ness is attended by increasing cost, transportation generally 
representing the expanding element in cost. Finally, we 
have the new enterprises in industries which are practically 
independent of local supplies of material and of the local 
demand for products. In these enterprises we may assume 
that no element in production is as yet fixed. They may, 
within limits, assume such magnitude as will give them com- 
mand over all the economies of large scale production. These 
economies have a determining importance in the choice be- 
tween a small business and one of moderate size; they are 
of less importance in the choice between a moderate sized 
establishment and a large one ; with further increase in size 
of establishment their importance dwindles. Perhaps there 
is no point at which further economies cease ; but there is a 
point at which they cease to be of practical importance. In 
economic language, the economies from concentration of in- 
dustry are subject to a law of diminishing returns. 



CHAPTER IX 

The General Law of Wages 

We have found frequent occasion in earlier chapters to 
touch upon wages and interest. Wages and interest are 
parts of the cost of production of commodities, as we saw 
in Chapter V, and as such have an important part to 
play in determining values. As incomes of great social 
classes, they are, however, of far greater importance. In 
the present and the following chapters we shall endeavor 
to ascertain the laws determining the rates of wages, interest, 
and whatever other forms of social income may remain after 
the shares of the laborer and of the capitalist are paid. In 
other words, we are entering upon a study of the distribution 
of wealth, or, more properly, of the distribution of the social 
income. 

Political economy, like most other sciences, often finds 
reason for defining terms the general meaning of which has 
been known to us all since childhood. Who is so innocent 
of the realities of life that he does not know in a general 
way what is meant by the terms "labor" and "wages" .^ 
Nevertheless, it is still possible for intelligent persons to fall 
into fruitless dispute over the "rights of labor," when one 
means one thing by labor, another a different thing. The 
possibility of mistaking the meaning of one who talks about 
"v\^ages" is still greater. One independent farmer will say 
that the thousand dollars he obtains for his produce is 
"wages" ; another will say that it is mostly the rent of his 
land; still a third will regard the same income as chiefly 
profits. Such conflicting use of terms may be a matter of 
indifference in ordinary conversation, which is mainly de- 
signed to furnish entertainment, not instruction. Scientific 
discussion, on the other hand, demands first of all perfect 
agreement in the use of terms. 



INTRODUCTORY ECONOMICS 121 

Every expenditure of human energy having for its chief 
purpose the production or the preservation of economic 
goods, or the increase in the valuable qualities of existing 
goods, is labor in the economic sense of the term. Labor in- 
cludes not only the exertions of the manual workers, by 
whom actual changes in material commodities are wrought, 
but also the exertions of the foremen, superintendents, man- 
agers, under whose direction the manual tasks are advan- 
tageously performed. It includes the activities of police, of 
judge, and of legislature, upon whose efficient performance 
rests the possibility of continued production in most of the 
existing branches of industry. Labor does not include, how- 
ever, efforts undertaken for their own sake, without regard 
to economic result. The amateur football team spends an 
immense amount of energy, and gets its reward in the spend- 
ing. The amateur hunter often cares little or nothing for 
the birds he brings down ; his reward is the gratification of 
the prehistoric thirst for blood. The professional football 
player and the professional hunter, on the other hand, are 
laborers. If any one thinks that this is a distinction with- 
out a difference, let him ask the football amateur what claim 
to superiority he enjoys over the "professional"; let him ask 
the sportsman wherein the latter differs from the pot-hunter. 

As the term "wages" is generally used, it signifies the 
money or other things of value paid by an employer to those 
who serve him in capacities of inferior dignity; employees 
of higher rank receive "salaries." Political economy does 
not recognize any such distinction as this, based as it is upon 
the pretended social status of the recipient, rather than upon 
a difference of economic function. The ten cents a day paid 
to a child slave and the $100,000 a year paid to the president 
of an insurance company are alike wages in the blunt speech 
of the economist. Moreover, in economic language, the term 
"wages" extends to part of the income of a workman who is 
his own employer. One peanut vender may be working for 
a push-cart enterpriser, receiving a dollar a day for his ef- 



12^ INTRODUCTORY ECONOMICS 

forts. This sum, all will agree, is nothing but wages. At 
the opposite corner of the square you may find another pea- 
nut vender, who is his own employer. The latter may gain 
over and above the cost of raw nuts, gasolene, push-cart hire, 
etc., just a dollar a day. The two men then receive equal 
rewards for identical services. Possibly the second vender 
calls his income ''profits." Political economy cannot afford 
to use two different terms to designate essentially the same 
thing, especially when one of the terms, ''profits," has a very 
definite m.eaning of its own. Whatever a man receives sim- 
ply as a reward for his exertions, whether directly or through 
the intermediation of an employer, is wages. 

While we cannot properly exclude from the term wages 
so much of the income of an independent workman as arises 
from his personal exertions, we are nevertheless justified 
in devoting our attention almost exclusively to wages as 
determined by contract between employer and employee. An 
increasing proportion of the world's work is being done un- 
der this system; and most of the important economic prob- 
lems of the day are concerned with it. Who ever heard 
of a "labor problem" in an agricultural community where 
every farmer relies exclusively on his own two hands? In 
such a community, what importance attaches to the genera] 
movement of wages, whether upward or downward? In- 
deed, who can determine, in such a society, how much of 
the total income of each farmer is wages, how much interest 
on capital invested in the farm? Wages have existed ever 
since our first ancestors were condemned to eat their bread 
in the sweat of their brows ; but it is only under modern con- 
ditions, where one man pays another to work for him, that 
it comes to be of great importance to ascertain what laws 
govern the rate of wages. We shall therefore confine our 
study to that part of the economic field in which differentia- 
tion between employer and employee has taken place — where 
the "wage system" exists — and shall endeavor to ascertain 
the laws operative therein. These laws, indeed, exert an in- 



INTRODUCTORY ECONOMICS 123 

fluence in the rest of the economic field as well, and are in 
turn influenced by forces lying outside of the field in which 
the wage system prevails. What a man could get as his 
own employer helps to determine how much he must have 
as a mere wage-earner ; what he could get as a mere wage- 
earner helps to determine what he must gain as an inde^ 
pendent workman. 

Let us set before us, in imagination, an agricultural 
community in which all the land is owned by a few wealthy 
men who do not themselves engage in tillage, but hire the 
landless population to work upon their fields. And let us 
further assume that this population is unable or unwilling to 
migrate to other communities in search of employment. 
Whether there are many workmen or few, they must all 
seek employment upon the land, or starve. 

Some of the land in the community will naturally be 
fertile, some of it barren. Some of it will require a large 
expenditure of labor for every bushel of wheat or potatoes 
produced; some of it will yield rich crops with little labor. 
Every good field will yield a moderate crop with a small 
expenditure of labor ; if a larger crop is sought, it must be 
at the expense of a disproportionately large application of 
labor, as we saw in the chapter on Diminishing Returns. 

Accordingl}^, we may safely lay down the proposition 
that the results arising from the application of labor to dif- 
ferent fields, and in different methods of cultivation, will be 
unequal. Good land, in extensive cultivation, may yield 
three bushels of wheat per day's labor expended, while 
poorer land would yield, perhaps, two bushels and yet poorer 
land one bushel. Adding one day's labor to the amount pre- 
viously spent on a piece of the best land, may add only two 
bushels to the product, and adding still another day's labor 
may add only one bushel. 

Now, however unequal the results of labor on different 
fields and under different methods of cultivation, the reward 
of labor — wages — will be uniform, allowance made, of 



124 INTRODUCTORY ECONOMICS 

course, for differences in the physical efficiency of different 
laborers. Suppose that a farmer has ten fields, of different 
degrees of fertility, and employs one man to cultivate each, 
the work on the different fields being uniformly arduous. 
He would be a very unusual employer if he should propose 
to pay the men different rates of wages, according to the 
fertility of the field upon which each is employed. The 
probable result of such a plan would be that competition 
would arise among the men to win the employer's favor, 
each one desiring to be employed on the best field; and in 
the end we should probably find that the better fields would 
be apportioned to the men who would agree to perform for 
the employer various miscellaneous services which would, 
generally speaking, be equal in value to the advantages they 
enjoyed in the way of higher remuneration. How this would 
work out we might consider at greater length if we did not 
know by experience that even the fairest employer is averse 
to grading the wages of his men, not on a basis of their skill 
and faithfulness, but on a basis of the facilities for work 
which the employer himself furnishes. Cases of unequal 
rewards for the performance of equal tasks are of course to 
be found; but for these cases the explanation, as we shall 
see later, is of a wholly different nature. 

Just as uniform wages will be paid for like tasks by any 
one employer, so uniform wages will be paid by all the em- 
ployers in the community. No employer can keep in busi- 
ness unless he pays as good wages as any other. If any 
one raises wages slightly, he will attract to himself an in- 
creasing number of workmen; and he will soon get all he 
cares to have. In an earlier chapter we saw that there can- 
not be different prices for the same commodity in the same 
market. This law holds good for labor as for anything else 
one buys or sells. 

Of ten fields the best one, when cultivated by one work- 
man, may yield a product worth $500; the worst one may 
yield only $150. What will be the maximum wage that the 



INTRODUCTORY ECONOMICS 12$ 

employer will pay? Not more than $150. For he will not 
pay any workman more than the entire product created by 
the aid of that workman ; and he will not, of his own volition, 
pay one workman more than another. Nor can any work- 
man compel the employer to pay him more than the one on 
the worst field receives. Suppose that the one employed on 
the best field insisted on a wage of $200. The employer 
would dismiss him, and place on that field the laborer 
formerly employed on the worst field. And so with any one 
of the ten laborers. What the employer would lose, if any 
one of them should "strike," would be simply the product 
of the worst field — $150, according to our premises. 

If we assume that the ten fields are owned by different 
men, we arrive at an identical result. The employer who 
owns the poorest field cannot possibly pay more than $150 
to the workman who tills it. If a workman on a better field 
demands more, his employer will dismiss him, and put in his 
place the workman formerly employed on the poorest field, 
whom he can easily induce to change employers by offering 
him a trifle more than the owner of the poorest field is able 
to pay. The dismissed workman must live ; probably he will 
have to seek employment on the abandoned field, and content 
himself with the wages that the owner of that field can pay. 

If we assume, instead of ten fields of varying fertility, 
one large, fertile field, giving employment to ten men, we 
see exactly the same principle at work. One of the men, 
cultivating the land extensively, may produce $500 ; a second 
may add to this product $450 ; a tenth may add to the total 
product of the nine previously employed only $150. The 
employer will not pay the first $500, the second $450, and so 
on down to $150. He will pay each one not more than $150. 
If any one should demand more, he would be dismissed, and 
his functions performed equally well by the man who other- 
wise would have added only $150. What the employer loses, 
when he loses any man of the ten, is the product created by 
the least important one of them all. 



126 INTRODUCTORY ECONOMICS 

We have, then, an upper limit of wages above which an 
employer cannot be compelled to go : the addition to the 
total output created by the man who works at the greatest 
disadvantage. Is there, similarly, a lower limit? In the 
situation we have assumed — a number of competing em- 
ployers, each able to increase his employment of men 
through breaking up new, though less fertile lands, or 
through more intensive tillage of lands already under cul- 
tivation — it is unlikely that any employer will make a large 
net return on the last man he employs. Let us assume that 
the uniform yearly rate of wages is $120, while the product 
of the least important man varies from $120 on the least 
fertile farms to $175 on the most fertile ones. The man who 
has a fertile farm can increase his net income by offering a 
little more than $120 for an additional workman. Such a 
workman will not add $175 to the total output — the law of 
diminishing returns forbids this — but he may add $170. As 
the employer on the least fertile field secured a product of 
only $120 from his last man, he is compelled to let a man go. 
Perhaps the man who now becomes his least important hand 
is worth $125 to him, and $125 may be what the man on the 
next better field is worth. It still pays the farmer with the 
best fields to seek additional hands. The wage he must now 
offer is more than $125 — let us say, $130. And the addi- 
tional men will be worth less to him — perhaps $165 each. 
Competition will still go on between the employers having 
the better fields and those having fields that are not so good, 
each rise in wages affecting, of course, the wages of all the 
workmen in the community. At last a point is reached 
where no employer can take a workman away from his com- 
petitor without offering a wage so high as to outweigh the 
advantages to be derived from an additional employee. 
Here, then, wages will tend to remain stationary. Each 
employer will be paying his least important man so much 
that any increase in wages would make that man an un- 
profitable member of his working force. No employer 



INTRODUCTORY ECONOMICS 12/ 

would care to take on an additional man at the existing rate 
of wages. This means that on every farm the least im- 
portant workman adds to the total product only enough to 
cover his wages. The addition to product made by the man 
working under the least favorable circumstances is, then, not 
only the maximum that the employer can be compelled to 
pay; it is also the minimum which he cannot avoid paying. 
If we describe as the "product of labor" that amount of valu- 
able products which is brought into being by the presence of 
any particular laborer, we may say that, under competition, 
wages are determined by the product of the laborer working 
under the least advantageous circumstances (in this case, 
on the poorest land). This laborer is known in economics 
as the marginal laborer, as he is on the "margin" or fringe 
of employment, as it were — in a position where his continued 
employment is almost a matter of indifference to the em- 
ployer, since his presence means neither profit nor loss. In 
the customary economic formula, wages, under competitive 
conditions, are determined by the marginal productivity of 
labor (i. e., the productivity of the marginal workman). 

Now let us assume that the number of workmen in the 
community is increased by the immigration of equally ef- 
ficient workmen from another part of the country. The new 
men must have employment; and there is of course plenty 
of work in the community for them to do — on one condition, 
however. They must accept employment on fields yet poorer 
than any now cultivated, or they must be added to the force 
at work upon the better land, occupying themselves with 
tasks that formerly were neglected. In either case they will 
add less to the product than was created by the "marginal" 
workman before the arrival of the new hands. They must 
accept a rate of pay lower than that which formerly pre- 
vailed ; else no employer could afford to hire them. And as 
there will not be two rates of wages for equally efficient men, 
the general rate for all the workmen originally employed in 
the community must be reduced, If the immigration con- 



128 INTRODUCTORY ECONOMICS 

linues steadily, other things remaining the same, the mar- 
ginal product of labor, and with it the rate of wages, must 
steadily sink. 

Jf on the other hand some of the original landless popu- 
lation had moved away, some of the worst fields would have 
been abandoned, and it would have become impossible to 
cultivate the better fields as intensively as before. On each 
field the importance of the marginal man would have in- 
creased. If any employer persisted in paying the old rate 
of wages, his competitors, by ofifering a little more, would 
have enticed his men away. The tendency for wages to rise, 
with decline in the laboring population, would be as irre- 
sistible as the tendency for wages to fall with an increase in 
population. 

It may be worth while at this point for us to consider 
a position frequently taken by writers on the labor problem. 
They assert that full and free competition must end in the 
abject misery of the working population. One laborer, they 
say, will ofifer to work at a trifle less than the prevailing 
rate; soon another is compelled to limit his demands; and 
eventually the whole body is forced, by the action of one cut- 
throat laborer, to accept lower wages. These writers forget 
that competition of employers also exists, and that one can 
argue with equal cogency that any employer, by offering 
higher wages, can compel all employers to raise wages. In 
general we may say that competition, if full and free, neither 
lowers nor raises wages ; it simply equalizes them. 

Now let us suppose that in this community are found 
extensive tracts of marshy land, of practically no eco- 
nomic importance at all. A competent engineer enters the 
community, and at a comparatively low expense drains these 
lands and transforms them into the very best quality of till- 
able soil. The owners of the drained lands must have labor, 
and can bid a higher price than prevails generally. If the 
laboring population remains stationary, the effect of the new 
demand for labor is to withdraw men from the least favor- 



INTRODUCTORY ECONOMICS I29 

able situations and place them upon the new land. On every 
farm, the product of the marginal workman will be in- 
creased ; and wages will rise accordingly. If immigration of 
laborers is going on, the new demand for labor does some- 
thing to counteract the effect upon wages of the new supply ; 
if emigration is taking place, the rise in wages that would 
otherwise occur is emphasized. 

A similar influence may be exerted by a general im- 
provement in agricultural practice. It is said that by the 
use of seed corn which has been grown in an isolated field 
from which all barren stalks have been removed before ma- 
turity, the average yield of corn may be increased from ten 
to thirty per cent. This increased yield is obtained without 
additional labor, excepting a small amount entailed by the 
care of the seed corn field. The use of such seed corn in the 
community we are studying would increase the product of 
every laborer, that of the marginal ones as well as of the 
rest; and the competition of employers with one another 
would force them to raise wages in the measure of the in- 
creased marginal productivity. The introduction of a new 
forage plant, like Kaffir corn or alfalfa, might have a similar 
effect in increasing the productivity of the marginal laborers. 
So also might the use of a new kind of fertilizer, or the in- 
vention of a new agricultural implement. Almost all agri- 
cultural improvements, in fact, are likely to have the effect of 
increasing the productivity of labor and the rate of wages. 

It is not in the least necessary that such improvements 
find general application. An improvement increasing the 
productivity of labor on one-tenth of the farms will gener- 
ally lead to an increased demand for labor on those farms. 
The demand is met by the withdrawal of labor from the 
farms not affected by the improvement ; and this will result 
in raising the productivity of the least favorably situated 
laborers on those farms, and so will raise general wages. 

Up to the present we have had no occasion to consider 
the effect of changes in price upon the rate of wages. In our 



130 INTRODUCTORY ECONOMICS 

agricultural community, the prices of produce are, we may 
fairly assume, equal to the prices prevailing in the nearest 
large city, less cost of transportation to that city. If through 
some improvement in railway management or some change 
in railway policy, the cost of transportation is reduced, the 
local price of produce will be correspondingly increased. Be- 
fore this change, we have assumed, the product of the mar- 
ginal workman was worth just enough to cover his wages. 
After the change, his product is worth more than this. His 
wages must rise, for otherwise an active competition will 
spring up among the employers. By a similar process of 
reasoning, it would be easy to show that a rise in costs of 
transportation, with a consequent fall in local prices, would 
necessarily reduce the value product of the marginal la- 
borer, and with it the rate of wages. 

One other influence needs to be noted here : namely, a 
fall in the rate of interest. There are few farms that could 
not be made to yield a much larger product, if abundance 
of auxiliary capital were to be had at a low rate of interest. 
If a farmer must pay ten per cent, on borrowed money, he 
cannot build a good barn or drain a marsh until he has ac- 
cumulated a considerable amount of money of his own. In 
the meantime opportunities for labor which would be thrown 
open if capital were to be had at five per cent, lie untouched, 
and the existing labor supply is spread over barren fields, 
with consequent low productivity. Every reduction in the 
interest rate creates a new demand for labor, and withdraws 
part of the existing supply from the poorer fields, thus in- 
creasing marginal productivity and wages. 

We may now sum up the results of our study of wages 
under the assumed conditions. Wages are determined by 
marginal productivity of labor, but marginal productivity it^ 
self is subject to many and varied influences, such as arise 
from increase or decrease in number of laborers; increase 
or decrease in the amount of available land; the progress 
of improvements; the fluctuations in the interest rate. Let 



INTRODUCTORY ECONOMICS I3I 

US now see how far we can apply the same reasoning to the 
determination of wages under conditions nearer Hke those 
of modern industry, confining ourselves, however, to those 
parts of the industrial field in which competition exists 
among employers on the one hand and among workmen on 
the other. 

The first fact that we must take into consideration is 
that we cannot assume that in this wide field of industry 
every workman can enter upon direct competition with every 
other workman, and thus bring about an immediate equal- 
ization of wages. The journeyman tailor cannot be replaced 
by the excavator nor by the farm hand ; the cotton mill opera- 
tive cannot take the place of the iron and steel worker. At 
any given time, then, there may be many rates of wages, not 
one universal rate. How the rate of wages for any partic- 
ular class of laborers is determined we have now to consider. 
In the next chapter we shall see how the rate paid in one in- 
dustry may indirectly affect the rates paid in other industries. 

Let us take, as our typical industry, cotton spinning — 
an industry which still remains highly competitive. We may 
safely say that one rate will prevail in any one district, as 
the New England or the Lancashire centers. The movement 
of workers from mill to mill is easy, and higher wages in 
one mill would quickly attract workers away from other 
mills. 

Now, we cannot assume, as we did in our agricultural 
example, that the different manufacturers can ascertain how 
much their laborers are worth to them by simply dismissing 
a few, and estimating the loss of product resulting. If a 
mill works without a full complement of hands, a part of the 
plant will be idle ; and a part of the loss will be due to this 
fact. When a manufacturer is erecting a mill, however, he 
can and must forecast the productivity, measured in value, 
of labor. With a mill employing one hundred men, he can 
figure upon a certain output. Probably he has business cour 
nections which make it easy for him to secure a market for 



132 INTRODUCTORY ECONOMICS 

that output. The price at which he will sell is of course 
uncertain, but admits of approximation. He knows what 
he must pay for capital, or if he proposes to use his own 
capital, how much he could obtain in the way of interest if 
he loaned it to some one else. He knows what he v/ill have 
to pay for a manager, or if he intends to manage the mill 
himself, what salary he could otherwise command in a mill 
belonging to some one else. After calculating all such ele- 
ments in cost, and subtracting their sum from the estimated 
value of the product, he has a remainder which is a fair esti- 
mate of the worth of the labor of a hundred men. Similarly, 
he can calculate what a second or third or tenth hundred 
men would be worth to him, if he should decide to erect a 
larger mill. Possibly the second hundred men would be 
worth more to him than the first, and the third more than the 
second, owing to the economies of concentration which we 
considered in the last chapter. As the projected plant in- 
creases in size, a point is eventually reached where the manu- 
facturer has to figure upon increasing difficulty in obtain- 
ing capital, in managing so large a concern, in marketing his 
product. Additional laborers will be worth less to him, 
accordingly. 

The first hundred workers employed may be worth to 
the employer an average of $300 annually; the second may 
so increase the product as to be worth an average of $350 
annually ; the third, $400, and so on up to the sixth, who may 
be worth $600. A seventh hundred may be worth only an 
average of $550, and so on until a twelfth is again worth 
only $300 annually. What size of mill will our enterpriser 
decide to erect, and what rate of wages will he pay? Let 
us assume that every year ten new mills are erected for every 
hundred already in operation. Of course the enterpriser who 
erects a new mill knows that the owners of the mills already 
established will make considerable sacrifices in the way of 
increased wages rather than see their complement of employ- 
ees enticed away. He must therefore count either upon an 



INTRODUCTORY ECONOMICS 133 

existing surplus of labor, trained to the business, or upon 
new laborers who may be brought into the industry from 
other fields. Assume that the aggregate supply of unem- 
ployed cotton spinners and of untrained workers who can 
readily be drawn into the trade is equivalent to 10,000 
trained laborers for every hundred mills in the trade. The 
projectors of the ten new mills can then calculate on 1,000 
workers each. Each can pay his tenth hundred an average 
of $400 annually. If one employer attempted to place the 
figure at $350, he would find that his competitors would 
enlarge their plants, and deprive him of this unit of labor; 
if the men demanded $450, he would limit his employment to 
900 men, and the superfluous hundred would have to seek 
employment at disadvantageous terms from his competitors. 
Thus we see that the prospective marginal productivity of 
labor will play a chief role in determining what wages shall 
be throughout the industry. 

It is not necessary to go through our earlier reasoning 
to show that an increase in the number of cotton operatives 
will reduce the prospective marginal productivity of each 
one, and with it general wages in the industry ; or that the 
progress of improvements, changes in costs of transportation 
and in interest rates must affect the marginal productivity of 
labor. Nor is it necessary to seek for illustrations in other 
fields of competitive industry. Everywhere we should find 
the same principles at work ; uniformity of rewards for uni- 
form services ; a tendency for wages to be set at the marginal 
product of labor. Everywhere we should find that produc- 
tivity tends to diminish and wages to fall when the number 
of laborers increases, other things remaining the same; 
everywhere a tendency for productivity to rise with increase 
in artificial capital or in available natural resources. 

But it is far from the truth to say that competition pre- 
vails over the whole field of industry. There are problems 
connected with the wages paid by monopolistic concerns; 
with wages paid to persons who have no power to bargain on 



134 INTRODUCTORY ECONOMICS 

even terms with their employers. We encounter, moreover, 
a number of competing explanations of differences in wages. 
In one industry wages are high ; if we inquire the reason, v/e 
are told that it is to be found in the risks to life and limb 
peculiar to the trade. In another industry we find high 
wages ; we are told that the cause of this is the strength of 
the trade union. If we desire an explanation of the fact that 
wages are high in the United States and low in China, we are 
often told that the reason is that the Chinaman will live on 
rats and rice, while our workman must have three honest 
meals a day. How do these explanations square with the 
marginal productivity theory of wages sketched in the pre- 
ceding pages ? This we shall consider in the next chapter. 



CHAPTER X 
Influences Giving Rise to Differences in Wages 

In the last chapter we arrived at the conclusion that in 
so far as full and free competition exists, both on the side 
of the employers and on that of the employees, wages tend 
to a uniformity, and are determined by the marginal pro- 
ductivity of labor. In practice, however, we seldom find 
competition thus operating without check. In some cases a 
workman has to rely for employment upon a single employer, 
or a body of employers combined in a single organization ; 
in other cases, an employer has to obtain his labor supply 
from the membership of a trade union, which exists chiefly 
for the sake of restraining competition among the workmen. 
In yet other cases combinations of employers confront com- 
binations of workmen, and the wages determined upon are 
the result of a "collective bargain," which appears to express 
rather the relative strength of the two parties than the pro- 
ductivity of labor. 

Even where two-sided competition exists within an in- 
dustry, so that the productivity test obtains, we often find 
that there are barriers which prevent any large number of 
employers or of employees from entering the industry. In 
early modern times there existed great trading companies 
which enjoyed the exclusive right of trading in certain re- 
gions—the East Indies, the Levant, the Hudson Bay terri- 
tory. Any member of the company might fit out an expedi- 
tion, and trade on his own account; all the profits he ob- 
tained were his, not the company's. Thus there was compe- 
tition within the company, and the earnings of a member 
were in this sense competitive earnings. But persons who 
were not members of the company were not allowed to trade 
at all. Competition of outsiders was impossible; and thus 



136 INTRODUCTORY ECONOMICS 

in some measure the earnings of all the members in the com- 
pany were non-competitive — monopolistic. In a similar way, 
in many trades competition among workmen is fairly active ; 
but barriers of diverse nature exist to check outsiders from 
entering the trade. Hence the earnings of those who are 
in the trade are in one sense competitive, in another sense non- 
competitive, or monopolistic. Our present concern is to give 
due weight to these various considerations, and to determine 
how far they merely qualify the theory laid down in the last 
chapter, how far they impair its validity. 

We may begin with an examination of cases in which 
there are manifest inequalities of reward for equal services. 

A large part of the ready-made clothing in the United 
States is produced under the "sweating system." Under 
one form of this system, the "manufacturer" buys the mate- 
rials, but instead of having them worked up on his own 
premises, turns them over to a contractor, who agrees, for a 
stipulated price, to get the work done. The contractor then 
distributes the work among the needy persons of his ac- 
quaintance — those who are prevented by age, ignorance or 
other disabilities from seeking employment outside of the 
tenements in which they live. The lower the wage at which 
these people can be induced to work, the higher the profits 
of the contractor. He learns by experience to estimate the 
depth of their poverty and the intensity of their need, and 
makes his bargains accordingly. Among his clients are per- 
haps some who depend upon him alone for employment — 
Russian Jewish widows, fugitives from the cruelties and op- 
pression of their native land. These will work blindly, un- 
complainingly, for the most meager wage. What they will 
receive will be barely enough to keep them alive, and the con- 
tractor will make considerable profits out of their labor. 
Others of his clients are less helpless; they may not have 
children dependent upon them ; they may have a smattering 
of the English language, and so may learn of other oppor- 
tunities for employment; they may fall within the "sphere 



INTRODUCTORY ECONOMICS I37 

of influence" of another sweating contractor, who will also 
desire to secure their services. All these circumstances the 
contractor will take into account, and will grade his wages 
accordingly. Under the conditions, then, wages are paid, 
not according to productivity, but according to need, in the 
sense that those who are in the direst need are the most 
wretchedly paid. 

The above is perhaps an extreme case ; but one does not 
need to have a very wide acquaintance with practical affairs 
to know of instances which illustrate the same principle. 
It is only where the workman is ready and able to change 
employers whenever he feels that he is unjustly treated, or 
where he is a member of an organization which insists upon 
equal rewards for equal services, that an employer can be 
forced to pay wages which correspond with the marginal 
productivity of labor. Fortunately, the field in which such 
conscienceless discriminations are made is a comparatively 
narrow one, and grows still narrower with every improve- 
ment in the material conditions and every advance in the 
general enlightenment of the working classes. 

Somewhat analogous is the case of unequal wages, paid 
in different localities, for substantially equal services. In- 
stances of such inequalities have been given in Chapter V. 
We saw there how an enterpriser might gain important ad- 
vantages by establishing a new branch of manufacture in a 
locality where a supply of unemployed labor exists. Under 
the circumstances, it cannot be said that wages at the outset 
correspond with the productivity of labor. The enterpriser 
may be able fully to man his works while offering a wage so 
low that he makes a substantial profit even on the last work- 
man employed. This advantage, as we saw, cannot long 
continue. Other enterprisers will enter the field ; competition 
among them will raise wages, until a point is reached where 
no one can gain a profit by extending his operations and 
employing more men. This means that in the end each will 
be paying for marginal labor all that it is worth to him. 



138 INTRODUCTORY ECONOMICS 

Wages, as we saw, may still be unequal in the different 
localities. The abundance of natural resources — cheap coal, 
water power, etc. — or proximity to m^arkets or to supplies of 
raw miaterial, may give one locality a distinct advantage in 
production over another, and this advantage will be reflected 
in higher productivity of labor and higher wages. We need 
look no farther for the reason why the American iron and 
steel industries, enjoying unsurpassable deposits of ore and 
coal, are able to pay higher wages than their Belgian com- 
petitors, handicapped as are the latter by lean ores and 
costly coal. 

We may next consider the case of an industry controlled 
by a monopoly. Here equal wages may be paid ; but there is 
no reason for assuming that they will correspond with the 
marginal productivity of labor in the industry. Indeed, this 
is something we may be quite sure they will not do. Imagine 
that a monopoly controlled the entire iron and steel manu- 
facture of the United States. It might secure the services of 
50,000 men comparatively cheaply, as there are at least 
50,000 men who are so specialized by long service in the 
industry that they would shrink from the prospect of seeking 
other employment. A second 50,000 men would probably 
include many who would find little difficulty in entering other 
industries. To obtain the services of these, higher wages 
must be paid; and this would exert a decided influence in 
raising wages for those who are, as it were, committed to the 
iron and steel industry for good or ill. This would be still 
more true of a third 50,000; and to obtain the services of a 
fourth set of 50,000 men the monopoly would have to ad- 
vance wages considerably. Now the mere fact that the 
fourth set of 50,000 men may create an increase in the 
product which exceeds the wages demanded by them, is not 
a sufficient reason why the monopolist should employ them. 
The monopolist must set against the profit represented by the 
increased output, the loss occasioned by the increase in 
wages which will be demanded by the men already in his 



INTRODUCTORY ECONOMICS 139 

employ. We may, therefore, say that a monopolist will cease 
extending his operations at a point where the product of the 
last laborers employed considerably exceeds the wages which 
must be paid them. 

Although there are no monopolies so absolute as our 
imaginary iron and steel monopoly, the country is full of 
enterprises that have a limited monopoly power. In all of 
these the wages paid will fall somewhat short of marginal 
productivity in the industry. Wages may, of course, still be 
higher than in competitive industries; indeed, it is a com- 
mon thing for a monopoly to strive to win a reputation as 
a benevolent employer of labor. The monopoly, we may say, 
limits the amount of labor that may be employed in the field 
it controls, and thereby insures a high marginal productivity 
of labor. Part of the excess of productivity it turns over 
to the laborer in the shape of higher wages, in partial expia- 
tion of its manifold sins against the public. The remainder 
of the excess it retains, and adds to its profits. 

We may now enter upon a study of the forces which 
are responsible for the differences in wages in the various 
trades and occupations. And here we encounter at the out- 
set a difficulty which has not hitherto arisen to vex us. How 
can we say what differences in general rates really exist? 
In all our discussion up to this point, we have spoken of 
equal rewards for equal services. Of course if one brick- 
layer does twice as much work as another, he ought to re- 
ceive twice the wages. The essential equality of wages re- 
quires this. But if a tailor receives twice the wages of a 
bricklayer, how can we say that it is because he does twice 
as much work? Clearly, it is not possible to reduce tailor's 
labor to terms of bricklayer's labor, so as to show whether 
one is rewarded more liberally than the other. 

Let us suppose that there are half a dozen occupations 
in a community, all of which require of beginners about the 
same degree of intelligence, dexterity, and strength, al- 
though they differ as widely in their nature as bricklayer's 



140 INTRODUCTORY ECONOMICS 

and tailor's labor, so that no direct comparison of wages is 
possible. Is there any reason why differences in wages per 
day should exist? At first, we should expect, the choice of 
occupations would be more or less a matter of chance. A 
boy would enter one of the trades because his father exer- 
cised it; another, because his best friend intended to enter 
it, and so on. 

Once in the trade, a man would have to remain there, 
unless he wished once more to go through the tedious tasks 
of a beginner. The different trades would thus be walled 
off, as it were, one from the other. Mature reflection might 
convince a man that he had made a mistake in choosing his 
trade ; but this would not mend matters. His earnings would 
be wholly subject to the laws of his trade. If many men 
happened to be in the trade, and the demand for their ser- 
vices were limited, some of them would have to be set at 
unimportant tasks, which could not be well remunerated. 
And competition among the men would force wages down 
to the level of remuneration of these. If the trade were but 
scantily supplied with men, even the least important of them 
all might be employed at work that could pay a high reward, 
and so a high rate of wages would prevail. In each trade 
the rule that marginal productivity determines wages would 
apply ; but marginal productivity would be unequal, for men 
of equal native ability, in the different trades. 

In every trade, however, a constant supply of new re- 
cruits is necessary to keep its ranks full. And the prospec- 
tive apprentice has at any rate some freedom of choice. In 
one trade, he finds men discontented and impoverished; in 
another trade, he finds every appearance of prosperity. Un- 
less he is very blind, he will choose a trade in which the lat- 
ter condition prevails. So the tide of apprentices sets stead- 
ily away from the underpaid trades, and in the direction of 
the better paid ones. Failing numbers, in the former trades, 
raise the marginal productivity of labor ; increasing numbers, 
in the more prosperous trades, reduce wages there. Whether 



INTRODUCTORY ECONOMICS I4I 

this process will continue until perfect equality of rewards is 
established for men of equal native ability in different trades, 
we cannot say. The equalization depends upon the good 
judgment of the prospective apprentices in their choice of 
trades ; and these, like all men, are likely to err. But gross 
inequality, under the circumstances, could hardly long 
persist. 

Some of the differences in wages actually existing ap- 
pear to be fortuitous, as those assumed in the foregoing ex- 
ample. But some of these differences are clearly connected 
with the personal qualifications of the workman — his 
strength and skill, his intelligence and reliability. Others 
are connected with the different degrees of risk, agreeable- 
ness, and dignity of the employment itself. Still others de- 
pend upon trade union requirements, or legal restrictions. 
What we are concerned with here, however, is not to classify 
the causes of differences in the wages paid in different occu- 
pations, but to see exactly how these causes operate. 

We know, for example, that a dangerous occupation is 
likely to carry with it a higher remuneration than a safe one ; 
that an occupation requiring a long apprenticeship is 
ordinarily better paid than one requiring practically no train- 
ing at all. Why may we not say, then, that a part of a man's 
reward is for labor, part of it for risk? If a tedious appren- 
ticeship is necessary, may we not say that part of the reward 
of the journeyman is a compensation for the time and trouble 
spent in learning the trade? Such an explanation would be 
quite satisfactory if we actually found that, other things equal, 
wages were nicely graded according to risk, or to length of 
the period of apprenticeship — if, for example, we found that 
a workman in an occupation involving no appreciable risk re- 
ceived a wage represented by jir; an equally efficient work- 
man in an occupation involving a considerable risk received 
X -{- y, and a third workman, in an occupation twice as dan- 
gerous as the second, received x -\- 2.y, and so on. But we do 
not find in real life any such simple rule as this. Danger- 



142 INTRODUCTORY ECONOMICS 

ous occupations, we often find, are very ill paid in compari- 
son with occupations requiring no greater natural ability and 
entailing no risk worth speaking of. Almost the least remun- 
erative occupation that an able-bodied citizen of the United 
States can engage in is that of soldier, and this in spite of 
the fact that the Federal Government prides itself upon being 
a liberal employer. Certainly the risks of the occupation are 
considerable. A man who accepts employment as trainman 
on the American railways stands one chance out of one hun- 
dred and twenty of meeting a violent death within a year, 
and one chance out of nine of being injured. His average 
daily compensation will vary from $2.09, if he is a fireman, 
to $4.25, if he is an engineer. In either case, he is a man of 
more than average physical strength and general intelli- 
gence. If he is an engineer, he is also a man who has at 
least as much training as the average skilled laborer. What 
we really find is that in some cases no allowance appears 
to be made for risk; in more cases some allowance appears 
to be made for it, but that there is no apparent tendency 
for this allowance to vary regularly with the degree of risk. 
Similarly with different degrees oi skill. Ordinarily, the 
skilled laborer, who has undergone a long apprenticeship, 
receives a higher reward than the unskilled laborer of equal 
native intelligence. In some cases, however, this does not 
appear to hold true; and it is idle to attempt to show that 
there is any ascertainable proportion between degrees of 
skill and differences of remuneration. So also with disagree- 
ableness of work. Little, if any, allowance is ordinarily 
made for it in wages, although in some cases it seems to 
play a very important part. Clearly, then, it is not enough 
to say that wages are affected by risk, by skill required, by 
disagreeableness of occupation. We must know how these 
causes operate, and why they operate with such irregularity. 
Let us see if a concrete example will not make clear the 
relation risk actually bears to wages. Imagine that a gun- 
powder factory is erected at a distance of a few miles from 



INTRODUCTORY ECONOMICS 143 

a city of some size. And let us suppose that five hundred 
workmen will be required, and that they will be of a grade 
of skill that would command an average of $3 a day in per- 
fectly safe occupations. How much will it be necessary to 
add to this sum, to induce them to enter the powder works? 
Now, the first question that is likely to arise is : How 
much danger is there that the works will blow up? You 
do not know this ; neither do I ; nor, we may venture to say, 
do the workmen whom it is sought to employ. Perhaps 
there is no danger at all in the present stage of the powder 
manufacture. Powder mills have often blown up, however, 
and most of us would prefer to stay out of them. 

In every community, there are some men who do not 
seem to be in the least afraid of danger. They may know 
that destruction has befallen others ; but, each argues, every- 
body can't be killed; why should I be? Such men have su- 
preme confidence in their luck. Danger, real or imputed, 
does not influence their conduct. Now, if there are a thou- 
sand men of this kind in the city, it will be quite possible to 
man the powder mill without offering any more of an ad- 
vance in wages than would have to be offered by an enter- 
priser who proposed to establish a new shoe factory or nail 
mill. The powder manufacturer, as any one else starting a 
new enterprise, will offer wages a little higher than those 
prevailing in the city— ten cents more per day, perhaps. Not 
every one will jump at the chance to improve his wages; 
but the men who despise danger will one by one leave their 
former employments and enter the doors of the powder mill. 
Presently wages will be reduced to the general level. No 
man will for this reason leave the mill, nor need the enter- 
priser care if a few should do so, for there are still plenty 
of men in the city who are not disturbed by fear of accident. 
But suppose that instead of one thousand such men, 
there are only one hundred. The powder manufacturer will 
find that ten cents extra a day fails to bring the full com- 
plement of men. Perhaps he will offer twenty-five cents ex- 



144 INTRODUCTORY ECONOMICS 

tra ; and this may bring another hundred men, who fear for 
their lives, indeed, but desire the additional income ex- 
tremely. An additional twenty-five cents may bring another 
hundred, more timid or less eager for high wages. At the 
rate of $i a day above the prevailing rate, the enterpriser 
may be able fully to man his works. 

Now, we may ask ourselves, is this extra dollar a com- 
pensation for risk? Remember, there may be no real risk 
at all ; and it may be that it is nothing but the name of pow- 
der that has kept the workmen back and forced up wages. 
And how is it that a powder manufacturer is able to pay 
men for risk, at their own estimate — very likely a mistaken 
one, too? Well, the powder manufacturer is experiencing 
the ordinary incidents of his business. Everywhere powder 
manufacturers have to contend with the same indisposition 
on the part of the ordinary workman to enter their mills. 
Everywhere the amount of available labor is limited, rela- 
tively to the demand for it. And so the productivity of a 
laborer, measured in value of powder produced, is high, and 
wages may be high accordingly. If, however, the number 
of men who do not mind the danger were sufficient fully 
to man all the powder works, more powder would be pro- 
duced ; its value would be less, and the productivity of labor, 
in value, would fall until it corresponded with that of labor 
in other occupations requiring equal skill. 

If the risks to life and limb undergone by locomotive 
firemen and engineers were reduced by fifty per cent., 
through the introduction of better safety appliances, the 
improvement of track, etc., how much could wages be re- 
duced ? I have never heard of a railway president who pro- 
posed to spend the company's money in reducing the chances 
of accident, with the expectation that part of the cost might 
be met by a reduction in wages. Nor do we find that wages 
are particularly high in the sections of the country where 
transportation is conducted at the greatest cost in life and 
limb. Here, it appears, is a case in which a great industry 



INTRODUCTORY ECONOMICS 145 

is able to rely upon the existing supply of men who bear 
risks cheerfully, without any extra compensation. The mar- 
ginal laborer, in transportation, is no more productive than 
the marginal laborer in general industry ; therefore he is no 
better paid. 

The case is similar with disagreeable labor. Certainly 
men ought to have extra compensation for engaging in work 
that is dirty and malodorous. But if the amount of such 
work in a community is small, a very slight advance in 
wages is usually enough to draw a sufficient supply of labor- 
ers from other occupations. If the amount is large, part of 
the working force must be recruited from among the more 
fastidious. Higher wages must be paid. Here again we 
may ask : How can the enterpriser afford to pay higher 
wages for this kind of work? And the answer is the same. 
As labor is relatively scarce, its productivity is relatively 
high. 

The principles which explain the higher rewards that 
are usually received by skilled laborers are not essentially 
different. Where a long apprenticeship is necessary, only 
those young men who have sufficient perseverance to work 
through several years without pay, and who are sufficiently 
free from family obligations to be able to do so, can enter 
the trade. Here is a barrier which, unlike that of risk, can 
be surmounted by none without some difficulty. There will 
not, ordinarily, be any one who will set patiently about ac- 
quiring skill, without a reasonable expectation that he will 
earn higher wages than he would have been able to earn 
as an unskilled laborer. Men in the skilled trades are hence 
relatively scarce; their productivity is relatively high. 

If, however, a position requiring skill is one of superior 
dignity, or if the work to be performed is of a peculiarly 
agreeable nature, the number of men who will undertake 
the burden of a long period of preparation may be so great 
that the productivity of each and his reward will be 
insignificant. 



146 INTRODUCTORY ECONOMICS 

If entrance to a trade is controlled by the men who are 
already exercising the trade, we may be quite sure that in 
one way or another the barriers to be surmounted by the 
aspirant to a place in the trade will be made more formid- 
able. If, for example, the existing body of carpenters were 
given the right to admit to the exercise of the trade only 
those whom they chose to admit, the number of apprentices 
would be narrowly limited indeed. Carpenters' labor would 
become relatively scarce ; its productivity would be increased, 
and wages would rise accordingly. We do not to-day have 
trades that actually control apprenticeship in this absolute 
way. But we do find, in many parts of the country, that 
trade unions insist upon a limitation by the employer of the 
number of apprentices, and that they are able to enforce 
their demands in this respect. We also find, in many cases, 
that they hedge the employment of apprentices about with 
so many restrictions that an employer can hardly afford to 
have apprentices in his works. In some cases heavy fees 
are exacted from men who wish to become members of a 
trade union ; and persons who are not members of the union 
are not permitted to work at all. Most trade unions are bit- 
terly hostile to the establishment of trade schools by the 
state. This monopolizing tendency is not by any means con- 
fined to the trade union. It is reported that in Germany the 
medical profession is clamoring for a restriction upon the 
number of students to be admitted to the medical courses. 
There are, it is said, so many physicians and surgeons in 
Germany that it is difficult for most of the members of the 
profession to make a living. 

Apart from positive limitations of the nature described, 
such high qualifications may be prescribed by those already 
in a trade or profession that the number of new members will 
be narrowly restricted. In the middle ages, before a man 
was permitted in certain crafts to attain to the position of 
an independent master workman, he was required to prove 
his finished skill by the execution of a typical piece of work 



INTRODUCTORY ECONOMICS 147 

—his "masterpiece." The purpose of the masterpiece, orig- 
inally, was to insure a high grade of workmanship ; and its 
character was naturally prescribed by the masters already 
in the trade. But when those in the trade felt that there 
were masters enough, they sometimes prescribed a master- 
piece so difficult, or requiring such expensive materials, that 
an ordinary journeyman was effectively excluded from the 
mastership. To-day, although we have no masterpiece re- 
quirements, we do, in some cases, require the passing of an 
examination before a man is permitted to enter upon the ex- 
ercise of a trade. This also is designed to secure good 
workmanship. But it is easy to see how entrance examina- 
tions may be so distorted from their original purpose as to 
establish a restriction upon entrance to a trade. Such re- 
strictions have the effect of raising productivity within the 
trade. At the same time, they, of course, make it necessary 
for the rejected candidate to seek some other employment, 
which, very probably, is still more overcrowded. They in- 
crease productivity in one trade at the expense of a reduc- 
tion of productivity in another. Whether from a public 
point of view this is justifiable or not does not concern us 
here. What we need to hold clearly in mind is the way in 
which such restrictions work. 

Now let us suppose that a trade union, instead of limit- 
ing directly the number who practice the trade, fixes a stand- 
ard wage, and prevents any man in the trade from working 
for less. Can we say that this is a matter concerning merely 
the workman and his employer ; that if the workman receives 
a higher wage, the employer receives lower profits? By no 
means. If the union controls the entire trade throughout 
the country, fixing a uniform wage, the employer is, as a 
rule, injured very little, if at all. The effect of the estab- 
lishment of a fixed wage is to put a stop to all work in the 
trade where the productivity of labor is not equal to the 
wage set. Perhaps this will leave unemployed some of the 
men capable of practicing the trade. These will have to seek 



14^ INTRODUCTORY ECONOMICS 

Other occupations, reducing productivity there. The rule that 
wages tend to be equal to the marginal productivity still 
holds; although in this case it is marginal productivity that 
adjusts itself to wages rather than wages to marginal 
productivity. 

Finally, we may consider the effect of the so-called 
''standard of living" upon productivity and wages. There 
are some who believe that wages are adjusted to the average 
needs of the workman; and if these needs increase, wages 
must rise. What a man feels that he ought to have, in the 
way of the material necessaries and comforts of existence, 
is his standard of living. This, according to certain op- 
timistic social philosophers, he will get. Accordingly, if you 
are modest in your demands, you will receive a modest 
stipend; if you are convinced that the world owes you not 
only a living, but a good living, the world will kindly ac- 
commodate itself to your view of the matter. Certainly, this 
theory is a far more agreeable one, and far easier to grasp, 
than the laborious one presented in this and the foregoing 
chapters. How much truth is there in it? 

If you are planning to become a physician, you are likely 
to seek the advice of some who are now practicing the pro- 
fession. You will probably receive some such advice as 
this: "Whatever you do, don't make a physician of your- 
self. A physician must dress well ; he must live in a good 
house ; he must keep a carriage ; in short, he must live at great 
expense. And in the majority of cases, he will find great 
difficulty in obtaining an adequate income." Now, what this 
means is that physicians have a comparatively high standard 
of living, and that their average incomes are scarcely suf- 
ficient to meet all the demands upon them. You may not be 
deterred by the doleful account of the physician's financial 
difficulties. But is it not probable that, in the length and 
breadth of the land, hosts of young men are in this way 
turned to other professions ? If, on the other hand, the ma- 
jority of physicians were recommending their profession as 



INTRODUCTORY ECONOMICS 149 

one in which a good Hving is assured, is it not likely that 
many young men would be attracted to the profession? 
In the former case, the average income of the physician is 
likely to be increased by the growing scarcity of competent 
medical men; in the latter case it would be likely to be de- 
creased, by increase in numbers. 

If, then, the earnings in a profession or trade are not suf- 
ficient to command, on an average, the necessaries and com- 
forts that are deemed essential to happiness, some influence 
is exerted upon those entering the profession or trade. The 
standard of living thus exerts some slight influence, at least, 
upon wages. 

In the example just given, the effectiveness of the stand- 
ard of living in one profession depended upon the absence 
of a similar standard in other professions. Suppose that 
after getting the opinion of a physician as to the advisability 
of entering his profession, you apply to a lawyer for his 
opinion on law as a profession. "Whatever you do, avoid 
the law," he will probably tell you. Next, you go to one 
who has chosen journalism. *'I pity a young man who se- 
lects journalism as his profession," is probably what you 
hear. Then you go to a teacher. He shakes his head. "If 
I were a young man, I should choose some other profession." 
Indeed, if you do not happen upon one of the few optimists 
who still survive, you are likely to conclude that you may as 
well choose the profession toward which you were originally 
inclined, since all the professions seem to be inadequately 
paid. The fact is that most of us think that we need more 
than we get ; and the result is that no one profession is able 
to frighten aspiring youths into choosing some other line 
of activity. The standard of living of any profession, there- 
fore, has little effect upon its average earnings. 

Suppose, however, that a whole nation, practically, is 
afifected by this feeling of discrepancy between income and 
need. A considerable proportion of its young men will 
marry late or not at all ; children will be few, and, if immi- 



ISO INTRODUCTORY ECONOMICS 

gration is not active, the population will gradually decline. 
In every occupation, men will be withdrawn from the less 
important tasks ; the less fertile fields and the less productive 
mines will be abandoned. The marginal productivity of 
labor, and the average rate of wages, will increase. On the 
other hand, if a nation consists of people who will thank- 
fully receive little if they cannot get much, who will forego 
one luxury or comfort after another rather than change their 
traditional mode of life, no check upon population will exist, 
until the bare necessaries of existence are insufficient for all. 
Here, as elsewhere, it is because the productivity of labor is 
low that wages will be low. Such people will obtain only a 
bare minimum of existence, because that is all the marginal 
laborer is worth, not because that is all he needs. 

We may now sum up the principles which we have 
sought in the foregoing long array of apparently unrelated 
examples. The marginal productivity of labor is in most 
cases the immediate determinant of wages. Risk or dis- 
agreeableness of labor, the skill required, the barriers to be 
surmounted, the standard of life, may all affect the rate of 
wages, but only in so far as they afifect the marginal pro- 
ductivity of labor, through determining its supply. 



CHAPTER XI 
Capital 

Perhaps the most confusing term with which the stu- 
dent of economics has to deal is ''capital." Almost every 
writer on political economy has an independent view of what 
the term capital really includes. One writer, for example, 
assures the student that land can never be capital, while an- 
other asserts that it is always capital. One authority de- 
clares that a dwelling house is not capital, while another is 
certain that such a house is as much a part of capital as is 
any other form of wealth. When scientific writers disagree 
as to the meaning of a word, the best plan is often to return 
to the speech of the plain man, and find what the word means 
on his lips. Let us ask the plain man what he means by 
"capital." 

Suppose that we number among our acquaintances a 
clothing merchant. We ask him what he means by his capi- 
tal. "My capital," he will probably say, "is the money T 
have in the clothing business." If we question him further, 
he will admit that by "money" he means not actual coins 
or bills, but money's worth, in one form or another. Still 
further questioning will probably lead our merchant to give 
something like an inventory of his stock, a valuation of his 
building, an estimate of the "good will" attaching to the busi- 
ness (i. e., the value of the steady patronage which the con- 
cern has won for itself through upright dealings in the past). 

It is certain that the merchant will place in his inventory 
each one of the suits of clothes which he has for sale. But 
we cannot safely infer from this fact that a suit of clothes, 
as such, is capital. For if the merchant decides to take away 
one of them for his own wear, he no longer counts it as 
capital at all. The same thing is true of the suits of clothes 



152 INTRODUCTORY ECONOMICS 

that pass into the hands of his customers. Though the mer- 
chant may assure each customer that a particular suit is a 
"fine investment," he knows in his heart that he is speaking 
in metaphor; and this the customer knows as well. 

Thus it appears that whether a thing is capital or not 
must depend, not on the nature of the thing, but on the pur- 
pose for which it exists among a man's possessions. If 
for sale or for use in connection with one's business, it is 
capital ; if for the personal use of the owner, it is not capital. 

But this is only the beginning of the perplexity. A year 
later you may ask the same merchant what his capital now is. 
Very likely it is still $100,000. Now, is this the same capital, 
or is it a new one ? The merchant certainly will say that it is 
the same capital — unless, of course, he has lost, in the course 
of the year, his original capital and has replaced it from some 
new source. But how can the capital be the same after the 
lapse of a year? Nearly all the things that figured in the 
first inventory, except the building and the good will, have 
been replaced, in the second inventory, by objects which may 
be of a quite different character. In the first inventory, per- 
haps, cheap grades of goods preponderate; in the second 
these may be largely replaced by higher grades. However 
this may be, there can be no denying that the goods have 
changed, yet the merchant says that the capital is the same. 

Perhaps we are making ourselves unnecessary difficul- 
ties in our endeavor to arrive at the merchant's meaning 
when he says that his capital remains the same even after 
most of the things originally composing it have left his pos- 
session. Perhaps he means simply that he has as large a 
capital at one time as at another. Two things that are equal 
in magnitude are of course not the same thing, but we often 
speak of them as if they were. 

Yet if we reflect upon it, this does not appear to be what 
the business man means. Suppose that fire or flood had 
destroyed his store and stock, and that a rich relative, to set 
him on his feet again, had given him $100,000 to replace 



INTRODUCTORY ECONOMICS 153 

them. The merchant would not say that he was continiiing 
in business with the same capital, although in magnitude it 
would be the same. Clearly, a business man thinks of his 
capital as something that is capable of remaining perma- 
nently the same although the goods that compose it are 
constantly changing. And this conception we shall adopt, 
as it is, on the whole, one of the simplest of all that have 
been proposed, and one which gives perhaps a better ap- 
proach to the problems connected with capital than would 
any other. We may define capital, then, as a fund of pro- 
ductive wealth, which has the power of self-perpetuation. 
To quote from Professor Clark, "we may think of capital 
as a sum of productive wealth, invested in material things 
which are perpetually shifting — which come and go con- 
tinually — although the fund abides. Capital thus lives, as 
it were, by transmigration, taking itself out of one set of 
bodies and putting itself into another, again and again."* 

These material objects, in which a fund of capital is in- 
vested, do not, in ordinary language, bear a characteristic 
name. Following Professor Clark, however, we shall call 
them "capital goods." A merchant's stock in trade, his 
building, the land upon which his building is situated, are 
capital goods. That part of the merchant's capital which re- 
sides in his stock may change its material embodiment a 
dozen times a year ; that part which resides in the building 
may not wholly change its form in less than fifty years ; that 
which is invested in land may remain unchanged for an in- 
definite period. Thus, according to the character of the 
capital goods, "transmigration" from one material form to 
another takes place with greater or less frequency. 

Let us now try to see, in the concrete, what this process 
of "transmigration" really is ; we shall then be able to arrive 
at a clearer view of the nature of capital. An enterpriser 
possessing $100,000 in cash proposes to establish a clothing 
store. The first thing he must consider is the best location 
"^The Distribution of Wealth, pp. 1 19-120. 



1^4 INTRODUCTORY ECONOMICS 

for his business. He must find a place where, he has good 
reason to believe, the goods in which he proposes to deal will 
sell at a higher price than that which he must pay for them. 
This, of course, is comparatively easy to do Goods, as they 
come from the factory, may in a physical sense be ready for 
use ; economically, however, much remains to be done before 
they can be placed where they will fulfil their ultimate pur- 
pose — -the direct satisfaction of human wants. They must 
be conveyed to places where they are accessible to the con- 
sumer; they must be so arranged that inspection is easy. 
Expert clerks must be at hand to point out their good quali- 
ties and explain away their bad ones. This means that a 
considerable addition to the value of goods may be made 
after they have left the factory; and this addition, properly 
speaking, is the product of the mercantile establishment as a 
whole. 

We need not stop simply with the affirmation that this 
increase in value is the product of the mercantile establish- 
ment in its entirety. Part of it is the product of the clerks 
and of the labors of the enterpriser himself ; part of it is the 
product of the building in which the goods are housed ; of 
the counters and shelves ; of the display windows ; of the 
elevators and the lighting and heating apparatus. And while 
it would be difficult, after the establishment is under way, to 
appraise exactly the services of each laborer and each ap- 
pliance, the enterpriser must, at the time when he founds his 
business, form some idea of what these services will be, in 
order that he may adjust his outlay accordingly. 

Each item of the stock ought to sell at a price which will 
at least replace that item with one of equal value, together 
with a surplus which will cover the cost in labor employed 
in handling it, and which will also make some contribution 
to the expense of keeping up the building. Any item which 
does not do this is carried at a loss ; and a business man who 
should continue to carry such items would be in danger of 
seeing his capital diminish, and perhaps ultimately disappear. 



INTRODUCTORY ECONOMICS 155 

Some parts of the stock may afford a far larger surplus, and 
the aggregate income of the establishment may be much 
more than enough to keep stock and store intact, after pay- 
ing for all human services directly employed. The nature 
of this excess of income above outlay we shall consider at 
a later point. For the present we are concerned primarily 
with the fact that the first demand upon the business is that 
each item should maintain itself — i. e., through sale, repro- 
duce itself together with auxiliary costs connected with it. 

We may in a similar manner follow in imagination the 
process whereby capital persists through transmutation in 
a manufacturing establishment. An enterpriser with $ioo,- 
000 in cash decides to erect a cotton mill. The difference 
between the aggregate value of the product — cotton yarn — 
and the value of the raw cotton represents the gross value 
product of the mill. And this product is in part due to labor, 
in part due to machines and building, fuel and power plant. 
Each grade of yarn produced in the mill should, at the 
very least, replace through its selling price the raw cotton 
and fuel consumed, the wear and tear of machines and other 
appliances, and the cost of the labor employed in connection 
with it. The enterpriser will quickly discontinue the pro- 
duction of a grade of yarn which does not do this. Some 
of the grades — probably all — will produce a surplus above 
the costs which have just been enumerated. 

This surplus, as well as the sums necessary for the 
repair of building and machinery, the replacement of raw 
material and fuel consumed, first appears in the selling price 
of the cotton yarn. This selling price is the joint product of 
the labor, materials, fuel and machines; and the manufac- 
turer must be able to estimate how much each machine, each 
bale of cotton, each ton of coal, contributes. Every capital 
good must produce a value at least equal to its own before it 
wears out. Otherwise there results to the manufacturer a 
net loss from its use. 

It must now be clear how it is that a fund of capital 



156 INTRODUCTORY ECONOMICS 

persists. Each capital good, before it is sold or worn out, 
produces a sum of value that enables the owner of the good 
to purchase or make another good of the same character, 
which in its turn possesses the power of replacing itself by 
a successor of equal value. The capital goods of this year 
are therefore not merely the successors in time of those of 
last year, now mostly destroyed. They are, economically, 
the offspring of the capital goods of the earlier period, and 
they inherit from their predecessors the same power of re- 
placing themselves with other goods having the power of 
self-replacement. 

It is, of course, to be understood that this self-replace- 
ment is neither automatic nor inevitable. We may say that 
under certain conditions a particular capital good will add 
something to the total product of an industry, but not enough 
to keep itself in repair and replace itself when worn out. 
Under other conditions a capital good will just do this ; un- 
der still other conditions a capital good will add to the 
product of an establishment not only enough for its own 
repair and replacement, but a surplus besides. Experience 
has taught enterprisers how to avoid the employment of 
capital goods that do not maintain themselves, and of those 
that do nothing more than this. Mistakes are of course 
sometimes made, but not so frequently as to invalidate the 
statement that capital goods, as a rule, reproduce them- 
selves economically through the values which they create. 
Intelligent action on the part of the owner of such goods is 
essential to the truth of this proposition; but such action 
may generally be taken for granted. 

But perhaps it is not yet entirely clear that the capital 
to-day embodied in a merchant's stock is essentially the same 
capital that will exist a year hence, when the concrete capi- 
tal goods will all have changed. An illustration from a 
related field may help to remove the difficulty. A man has 
in his purse, let us say, a one hundred dollar bill; he ex- 
changes it for ten gold eagles. Does he continue to have the 



INTRODUCTORY ECONOMICS 1 57 

same hundred dollars ? For all practical purposes, yes. The 
hundred dollar bill represented a certain purchasing power ; 
the ten eagles represent not a new purchasing power, but 
identically the same one. True, the eagles may happen to 
be a more convenient form in which to clothe this purchas- 
ing power. So a merchant may have $ioo of his capital in 
the form of shoes, let us say. To-morrow he may part with 
the shoes for cash, with which he may purchase hats. Again 
the capital is turned into cash ; again it is reinvested in capi- 
tal goods. The hundred dollars worth of capital with which 
we started represented a certain amount of productive 
wealth. Soon it took the form of money, only to be trans- 
formed again into goods, and so on indefinitely. The hun- 
dred dollars after each act of exchange is not a new produc- 
tive power added to the wealth of its owner ; it is a new form 
assumed by the original productive power. 

A threshing machine may continue in good order for 
ten years ; at the end of that time it begins rapidly to run 
down, and after fifteen years of operation it may have to 
go to the scrap heap. In the fifteen years of the machine's 
life it probably yields, as we have seen, a sum at least suf- 
ficient to replace itself. This sum will begin to accumulate 
in the early years, existing first as a part of the product 
which the machine assists in creating — threshed wheat — 
then in the form of money, the price of the wheat. It is 
unlikely that the owner of the machine will keep the replace- 
ment fund in the form of idle cash; more probably he will 
transform it into some other form of productive wealth — 
cattle or hogs, perhaps. Long before the machine is worn 
out these have reached maturity and have been sold, and the 
proceeds of the sale reinvested. If we look at the process 
from an economic viewpoint we shall see the threshing ma- 
chine gradually transforming itself into an increasing herd 
of live-stock. When at last the machine is abandoned, the 
capital formerly resident in it exists in the form, let us say, 
of a herd of cattle. This capital may be transformed into 



158 INTRODUCTORY ECONOMICS 

cash through sale, and the money may in turn be exchanged 
for another threshing machine. Or, the money may be used 
to purchase shares in an ironworks or a weaving mill. In 
the latter case we have an instance of capital shifting from 
industry to industry. 

We have seen how capital, once in existence, perpetuates 
itself; we must now discover the conditions under which 
it comes into existence. It may^at first appear that capital 
comes into existence whenever a productive instrument is 
created. Reflection shows, however, that this cannot be 
true, for a new capital good often merely embodies the capi- 
tal formerly existing in a capital good which has reached 
the limit of its usefulness. 

When a man employs, in producing a tool or a stock of 
the materials of production, time which he would otherwise 
have used to procure for himself the means of immediate 
enjoyment, he is creating capital. These capital goods are 
not merely replacing capital goods previously existing; they 
are a net addition to the stock of productive wealth at the 
command of society, which like other capital goods will 
for the future maintain themselves. When a man uses, to 
employ workmen in the production of capital goods, a part 
of his income which he would otherwise have spent for con- 
sumer's goods, he is causing new capital to be created ; or, 
we may say, he is indirectly creating capital. When he uses 
part of his income to buy capital goods that are already 
in existence, he is creating new capital by a still more in- 
direct process. Thus if a man buys a threshing machine out 
of his savings, he places in the hands of the manufacturing 
company purchasing power with which the company can hire 
men to make another machine. The process of creating new 
capital may take a yet more roundabout course. The man 
who saves may invest his savings in a share of railway stock 
— which is nothing more than an evidence of ownership of 
property already existing. The man who sells the share of 
stock may use the proceeds to buy a share in a manufac- 



INTRODUCTORY ECONOMICS 159 

turing company. Here again it is evident that nothing new 
is created. The seller of the manufacturing stock may, how- 
ever, use the money to buy a share in a new manufacturing 
company, and this company may employ the proceeds to hire 
men to produce new capital goods for use in its business. 
Evidently it is the man who saved the money in the first 
instance who is the true creator of the capital thus added to 
the stock of society. 

Under present conditions the process of creating capital 
is usually indirect. One man saves and other men produce 
the concrete capital goods in which the savings are invested. 
Of course it sometimes happens that such a complicated 
process fails to attain its proper end. One man may 
save $ioo and buy a share of stock from another man, 
who uses the proceeds to meet his current expenses. 
In this case no new capital is created. What has happened 
is that a part of the existing fund of capital has changed 
hands. But normally men avoid trenching upon their capi- 
tal; accordingly we are justified in regarding each act of 
saving as the creation of new capital. 

Just as it is improper to regard the creation of a capital 
good as in itself a creation of capital, so it is improper to 
regard the destruction of a capital good through use as the 
destruction of capital. For during its lifetime a capital good 
produces, as we have seen, a replacement fund. After the 
capital good has been destroyed the capital exists under an- 
other form — as money or as other productive goods con- 
stituting a replacement fund. The capital is destroyed only 
if the replacement fund is used for consumption instead of 
being reinvested in productive wealth. 

Capital is a fund of productive wealth embodied in con- 
crete capital goods. We must nov/ ascertain the nature of 
the productivity of capital goods and of capital, and the 
methods by which such productivity may be measured. For 
that the business man does measure the productivity of each 
capital good and of each unit of capital is evident. Other- 



l60 INTRODUCTORY ECONOMICS 

wise how could he know how much he can afford to pay for 
the capital goods which he buys or for the capital which he 
borrows ? 

In the case of some classes of capital goods the test is 
easily made. Thus if one wishes to know how much a ton 
of fertilizer will produce, he has only to apply it to one of 
two acres of ground of practically equal fertility. The dif- 
ference in the product of the two acres, less the cost of labor 
employed in applying the fertilizer, is a fair test of the pro- 
ductivity of a ton of fertilizer. We may term this the gross 
product of the capital good. After deducting from this 
product a sum of value sufficient to replace the fertility de- 
stroyed through the year's cropping, whatever remains is 
the net product of the capital good. 

It may be that in the existing state of agriculture satis- 
factory crops cannot be produced without the use of a certain 
amount of fertilizer. Let us suppose that five tons per acre 
are generally applied to land of a given grade. No practical 
farmer will be at pains to ascertain how large a share of the 
crop is the product of this amount of fertilizer. But if there 
is a possibility that an additional ton will pay, progressive 
farmers will experiment with that additional amount. In 
practice men get an idea of the productivity, not of every 
part of their supply of a given kind of capital goods, but of 
that part of the supply which is least essential to the conduct 
of their business. It is the productivity of this least essen- 
tial part of the supply that it is most important to know, for 
this knowledge shows whether one should increase his busi- 
ness or restrict its scope. 

Productivity, in the case of such capital goods as fer- 
tilizer, is ascertained through the efifect of the removal or the 
addition of a small quantity of the capital good. Some 
capital goods do not readily admit of any such process of ex- 
perimentation. Thus it might be difficult to determine the 
productivity of a field, apart from that of the seed, fertilizer, 
machinery and labor employed in connection with it. Of 



INTRODUCTORY ECONOMICS l6l 

course one might leave one acre untilled, employing all 
the labor and auxiliary capital on the rest of the field. 
The total product would be less than it would have been had 
all the field been tilled ; and this diminution in product would 
indicate roughly the productivity of an acre of ground. This 
method is a clumsy and expensive one, and so far as I know 
is never employed in practice. It is, moreover, unnecessary, 
since the productivity of labor and of auxiliary capital em- 
ployed upon the land may be determined, for the most part, 
by the method already illustrated. Hence we may arrive at 
the gross product of the field by subtracting from the total 
product of the farm the values produced by the labor and 
the auxiliary capital. By subtracting from the gross product 
of the land a sum of value sufficient to replace the elements 
of fertility destroyed in the course of the year, we arrive 
at the net product of the land. 

The cotton manufacturer would find it impossible to 
distinguish, in a physical sense, between the product of his 
looms and the product of his engines. Neither looms nor 
engines would produce anything the one without the other. 
The manufacturer can, however, ascertain how much greater 
the productivity of one kind of loom is than that of another ; 
similarly, he can measure the differences in productivity of 
different types of engines. Now it is exactly this that it 
is of practical importance to know. If one intends to manu- 
facture cotton cloth he must have some kind of looms and 
engines. But what kind? One kind of loom costs x; an- 
other kind, x-\-y. What the manufacturer needs to know 
is whether the extra product of the more expensive loom is 
sufficient to maintain the capital which we have represented 
by the symbol 3;. Unless it does this, the manufacturer will 
have to employ the cheaper loom. 

From the foregoing discussion it appears that the pro- 
ductivity, not of every form of capital goods, but of only 
those that are in a position which makes it possible to dis- 
pense with their services, is readily determinable. Marginal 



l62 INTRODUCTORY ECONOMICS 

productivity is the only form of productivity that is defi- 
nitely ascertainable. What determines marginal produc- 
tivity we shall consider in the next chapter. 

It is obvious that the productivity of capital goods must 
vary widely, since some capital goods must produce enough 
to replace themselves every day while others need only 
a trifling allowance for repair. Thus $ioo worth of 
coal — a day's fuel for a factory — must yield in one day 
a value of at least $ioo. Let us suppose that it does a little 
more than this — that it produces each day $100.02. Every 
day, after replacing his fuel supply, the factory owner may 
set aside two cents — ^the net product of the coal. In the 
three hundred working days of the year the net earnings of 
all the coal consumed will be $6. In the same establishment 
there may be a machine costing $100 which produces a gross 
return of only $16 during the entire year. Yet $10 may be 
enough to keep the machine in repair and to provide a year's 
proper contribution to the replacement fund. Six dollars 
will then be the net product of the machine. 

Now, the net product of capital goods is what we mean 
by the product of the capital invested in the goods. The 
$100 worth of capital invested in coal produces two cents a 
day, or $6 a year; the $100 invested in the machine produces 
an identical sum. While capital may differ in its productiv- 
ity under different circumstances, there can be no such vari- 
ation as in the case of capital goods. The productivity of the 
latter must vary on account of the differences in the time for 
which the different classes of capital goods can be used. 
Capital, on the other hand, is all equally permanent ; variation 
in productivity is therefore not inevitable. 

It is also obvious that the practical man will concern 
himself chiefly with the productivity of capital, not that of 
capital goods. He will strive to place his capital where its 
productivity is greatest, not to invest it in the goods which 
yield the greatest gross product. Accordingly, for the future 
we shall concern ourselves exclusively with the product of 



INTRODUCTORY ECONOMICS 163 

capital, remembering, however, that it is identical with the 
net product of capital goods. 

In order to ascertain the comparative productivity of 
different investments of capital, we naturally compare the 
capital sums invested with their respective returns, during a 
period of time — say, a year. This gives us results which are 
conveniently expressed in ratios — still more conveniently in 
percentages. The capital invested in a machine worth 
originally $120 yields, let us say $12 per annum. The ratio 
of annual product to the value of the capital is then one to 
ten, or ten per cent. The product of capital during a period 
of time thus reduced to a percentage of the capital value, is 
interest, in the economic sense of the term. In ordinary 
usage, it is true, the term interest is usually confined to pay- 
ments for the use of borrowed capital. But it is clear that 
the nature of the return is the same whether one uses his 
own or borrowed capital. 



CHAPTER XII 
The Rate of Interest 

In the last chapter interest was defined as the product 
of capital through a period of time, expressed in the form of 
a percentage of the value of the capital sum. In order to 
understand the forces governing, at any particular time, the 
rate of interest, we must therefore enter upon a study of 
the productivity of capital, or the net product of capital 
goods. 

For convenience we may begin our study with an exami- 
nation of the manner in which a practical business man would 
determine the productivity of a particular form of capital, 
as, for example, capital invested in agricultural machinery, 
live stock, and whatever other movable capital goods may 
be necessary for conducting agricultural operations. 

Let us assume that a farmer possesses ten fields, varying 
in natural fertility from a very high degree to a very low 
degree. And further let us assume that $i,ooo worth of 
capital in the form of machinery, stock, etc., or auxiliary 
capital, is necessary for the tillage of any one of the ten 
fields. 

If the farmer has control over only $i,ooo worth of 
auxiliary capital, he will of course place it upon the best 
field. If from the gross product of that field he deducts 
the cost of labor employed in connection with it, together 
with a sum sufficient to cover the cost of upkeep of land 
and stock, he arrives at the net product of his agricultural 
capital — that is, of fields and stock. How much is due to 
the bare land, how much to the auxiliary capital? This it 
would be difficult to say, as neither would have produced 
anything without the other. 

Now let us suppose that the farmer gets possession of 



INTRODUCTORY ECONOMICS 165 

another $i,ooo to invest in auxiliary capital. He may now 
till the field which is least inferior to the first one cultivated. 
The joint product of this field and of the $i,ooo of capital 
will be less than that of the first field because of the differ- 
ence in natural fertility. Shall we say that $i,ooo is more 
productive on one field than on the other ? The two units of 
capital are just alike; the two fields are unlike. So it would 
seem to be more reasonable to assign the difference in pro- 
ductivity to the fields, not to the auxiliary capital. And this 
is what a practical man would do. If the first field produces 
$1,000 and the second $900, we may properly say that at 
least $100 of the product of the first is the product of the 
land, apart from that of the auxiliary capital. 

Is the $900 produced on the second field the product of 
the auxiliary capital alone? In a physical sense, certainly 
not; in an economic sense it is. This sum is what the addi- 
tional $1,000 worth of auxiliary capital adds to the farmer's 
income. $900 is what he would lose if he were deprived of 
either of his two units of capital. 

With another $1,000 the farmer is enabled to till a third 
field, which is somewhat less fertile than the second. Per- 
haps this field produces $800 net. If this is the case the 
farmer will no longer regard the total product of the second 
field as the product of the auxiliary capital alone. This 
auxiliary capital produces no more than that on the third 
field — $800. The other $100 now comes to be considered as 
the product of the land. At the same time, of course, a 
second $100 is subtracted from the product of auxiliary 
capital on the best grade of land. And as the farmer adds 
unit after unit of auxiliary capital and opens field after field 
to tillage, the productivity of auxiliary capital steadily 
shrinks and that of the better land as steadily increases. 
Perhaps the tenth field yields a net return of only $100. In 
such case no one of the ten units of auxiliary capital can be 
said to yield more than this. The use of no one of the units 
is worth more to the farmer than $100, for if any one were 



1 66 INTRODUCTORY ECONOMICS 

taken away from his control he would replace it with the one 
employed in connection with the poorest field. 

We may demonstrate the same principle on the assump- 
tion that instead of ten fields of varying productivity the 
farmer possesses a single large and uniformly fertile farm. 
If the whole farm is cultivated extensively by the aid of 
$1,000 in movable capital goods, the net product, defined as 
above, may be $i,ooo. A second $i,ooo unit of auxiliary 
capital would no doubt greatly increase the net product, but 
the law of diminishing returns forbids us to believe that it 
would add $i,ooo to the product. Perhaps the second unit 
would add $900. This sum then measures the importance to 
the farmer of either unit of auxiliary capital. The extra $100 
appearing in connection with the first unit of auxiliary capi- 
tal may be regarded as the product of the land. A third 
$1,000 would still further reduce the productivity of each 
unit of capital and cause a larger share of the total product 
to be ascribed to the land; a tenth unit might add only $100. 
This sum then measures the loss that the farmer would 
incur if any of the ten units of capital were taken from 
his control. 

In the foregoing examples it has been assumed that the 
farmer is in possession of a fixed amount of land while the 
auxiliary capital at his command is subject to variation. 
This corresponds roughly with the facts of life ; yet for the 
sake of getting a clearer view of the principles governing the 
productivity of capital we must supplement the above dis- 
cussion by a reversal of the assumptions. The farmer has, 
let us say, $10,000 in auxiliary capital; the amount of land 
under his control is not determined. If he employs all his 
auxiliary capital in connection with a $1,000 tract of land — 
which we shall call a unit of land capital — he may secure a 
net capital product of $1,000. A second unit of land capital 
may add $900 to the aggregate net product. As the 
two units of land are by assumption alike, neither can be 
said to be more productive than the other; and the second 



INTRODUCTORY ECONOMICS 167 

one, we have assumed, produces $900. The extra hundred 
appearing in connection with the first unit of land is there- 
fore ascribable to the auxiHary capital. A tenth unit of land 
capital may add only $100 to the product of the business. 
Under the circumstances, no unit of land adds more. For if 
any one of the ten is taken from the control of the farmer, 
what he loses is merely the $100 that would have been pro- 
duced by the tenth unit. 

The principle involved in the cases that have been 
discussed may be stated as follows : The productivity of 
any unit of capital embodied in a given class of capital 
goods is measured by the amount added to the aggregate 
net product of a business by that unit which it is least 
worth while to employ. The same principle holds true of 
capital in general. 

Suppose that a farmer can command practically an in- 
definite amount of agricultural capital, whether in the form 
of land or in the form of movable capital goods, but that 
the amount of labor that he can secure is limited to ten men. 
With $5,000 invested partly in land, partly in movable capi- 
tal goods, he may be able to produce $5,000 net. We should 
here find difficulty in determining what part of this sum is 
produced by the labor, what part by the capital. An addi- 
tional $5,000 of capital m.ay increase the aggregate product 
of the business by $4,000. This sum we should properly 
ascribe to the new capital. And as this second unit of capi- 
tal does not differ in any essential respect from the unit at 
first employed, and as the removal of one unit of the two 
would have the same effect as the removal of the other, we 
may properly regard them as equally productive. The extra 
thousand appearing in connection with the first unit must 
then be assigned to the other factor in production — the 
labor. If a third unit of capital increases the product of the 
business by $3,000, this amount will measure the importance 
of any one of the three units of capital. This is what the 
farmer would lose if he were deprived of the use of any of 



1 68 INTRODUCTORY ECONOMICS 

the units. If a fifth unit adds only $i,ooo, the product 
assignable to any unit shrinks to that figure. And of 
course with each reduction in the product assignable to 
capital, the product assignable to labor increases. 

Up to the present point our study of the productivity 
of capital has been confined to the single business establish- 
ment. We must now consider whether similar principles 
are applicable to an industry in its entirety. The iron and 
steel industry of the United States may serve as our type. 

The capital at present engaged in the production of iron 
and steel may be placed at about $500,000,000 ; the number 
of men, at two hundred thousand. Now let us suppose that 
without any revolutionary change in the demand for iron 
and steel the capital of the industry is increased by $100,- 
000,000. What will be the effect upon the productivity of 
capital in the industry? 

It is fair to assume that before the increase in capital 
those branches of the industry promising the highest profits 
were already pretty well developed ; that the richest deposits 
of ore and coking coal were already being exploited; that 
the best manufacturing sites had been selected. To what 
use, then, will the new capital be put? Some of the enter- 
prisers may attempt to duplicate existing plant. This 
requires additional labor, and such labor is to be had only 
by inducing new men to enter the industry or by enticing 
men away from other iron manufacturers. In either case 
an advance in wages would follow, which would soon 
become general throughout the industry. In the old estab- 
lishments as well as the new this would obviously reduce the 
share of the aggregate product which capital would receive. 
Again, the increase in iron and steel products thrown upon 
the market would lower prices. Thus, while the wages bill 
of an establishment per unit of product would increase, the 
value of each unit of product would diminish. 

If all the new capital were used simply to duplicate 
existing plant, the rise in wages would be very great. The 



INTRODUCTORY ECONOMICS 169 

industry would need one-fifth more men than it has at 
present, and these would be slow to appear unless they were 
offered very high wages. The fall in prices, moreover, 
would be a serious one, as the output would be increased 
about twenty per cent. Accordingly it is clear that the new 
capital would not be used in this way. Some of it would be 
employed to develop new branches of the industry, which, 
under the earlier circumstances, were not regarded as 
profitable. Some of it would be used to replace worn-out 
blast furnaces by larger ones, requiring a smaller expendi- 
ture of labor per unit of product; some of it to provide 
better facilities for handling the material in its progress 
through the shops ; some of it to equip the mills with more 
nearly automatic machinery for manipulating the material. 
In these ways the pressure upon the labor supply would be 
somewhat relieved, and prices would be kept from sinking 
too low. The fact remains that the capital would be less 
productive after the increase than before it; wages would 
be higher and prices lower. The increase in the aggregate 
capital of the industry, other things equal, would reduce the 
productivity of each unit. 

The same principle is still more clearly applicable to 
industrial society as a whole. The iron and steel industry 
can relieve the pressure upon its labor supply by inducing 
men to leave other industries. If the capital of society as a 
whole increases, a similar pressure is placed upon the labor 
supply, for which there is no ready means of relief. The ex- 
isting capital is normally sufficient to provide every one who 
desires to work with the necessary appliances. If, then, the 
capital of all industries increases more rapidly than the 
population, the average capital employed with each laborer 
must increase. Such increase in capital must be embodied 
in improvements upon existing appliances, and owing to the 
operation of the law of diminishing returns, will increase the 
product of industry less than an equal amount of capital did 
when the social fund was smaller. 



170 INTRODUCTORY ECONOMICS 

There are of course conditions under which an increase 
in capital may not result in a reduction in the productivity 
of capital. If, for example, the labor supply increased more 
rapidly than the supply of capital, a larger share of the joint 
product of labor and capital would be imputable to the 
latter factor in production. Again, suppose that some cheap 
method of draining extensive swampy regions or of irri- 
gating vast tracts of arid land were discovered. Capital 
would then abandon the least productive existing invest- 
ments and flow into the new fields thus opened. The 
product of capital on the least attractive fields — which is the 
measure of the productivity of capital in all fields — would 
be greater after the change than before it. In like manner, 
an invention may increase the efficiency of capital through- 
out an industry and lead to the withdrawal of capital from 
the least productive investments and to an increase in the 
general productivity of capital. 

It has already been indicated that an increase in the 
amount of capital invested in one form of capital goods 
without a corresponding increase in the capital invested in 
other forms will reduce the productivity of capital in the 
one form while increasing the productivity of capital in the 
other forms. By placing more and more auxiliary capital 
upon a given area of land one must ordinarily reduce the 
productivity of auxiliary capital and increase the produc- 
tivity of land. It will naturally be the aim of the business 
man to keep his capital uniformly productive ; if he has too 
much auxiliary capital he will endeavor to get more land, 
and vice versa. He will ask himself: Would it pay me 
better to invest my next $1,000 in land or in auxiliary capi- 
tal? And he will continue to direct his investments toward 
whichever class of capital goods is for the moment the more 
productive, until the superiority of that class disappears. Of 
course to do so implies the necessity of taking some land 
away from his neighbors. If he cannot do this, he must soon 
cease to extend his business. 



INTRODUCTORY ECONOMICS I7I 

Similarly an entire industry may expand with more or 
less symmetry, distributing its new capital among the 
various classes of capital goods of which it stands in need. If 
the beet sugar industry expands, not only are more factories 
constructed, more machinery for the cultivation of beets 
purchased, but more land is drawn into the service of the 
industry. This land is, of course, taken away from other 
industries — wheat culture, dairying, etc. The increase of 
auxiliary capital in the industry may, therefore, not materi- 
ally affect the productivity of capital invested in land. 

When the social fund of capital increases, on the other 
hand, it is not possible for a symmetrical increase in all 
classes of capital to take place. The land, we may suppose, 
is already almost all in use ; the best mines are opened ; the 
most available courses for railways and canals are already 
occupied. These things the new capital cannot duplicate. 
On the other hand, steel rails, locomotives, factory buildings 
and thousands of other forms of capital goods are readily 
duplicated. It follows that with increase in social capital 
that which is invested in the former class of goods will 
probably increase in productivity, while that part which is 
invested in the latter class of goods will decrease in 
productivity. 

When, however, we speak of the productivity of capital 
in general, or of the rate of interest, we usually take as our 
test the productivity of new capital — and this, we see, is 
practically the capital in goods which are capable of duplica- 
tion. And instead of thinking of the old capital in non- 
duplicable goods as more than normally productive, we are 
likely to revalue the capital in such forms. Ten years ago, 
let us say, a five-acre lot gave rise to as large a net 
product as a threshing machine. To-day the same piece of 
land yields twice as large a net return as a threshing 
machine equal in value to the one of ten years ago. We 
might say that the capital in land has doubled in produc- 
tivity. But it is more usual to say that the land represents 



172 INTRODUCTORY ECONOMICS 

twice as much capital as the threshing machine, to-day, 
although it represented no more capital than the threshing 
machine ten years ago. By a similar process of revaluation 
the productivity of all capital which is abnormally produc- 
tive is reduced to the general level. This process of revalu- 
ation will receive our further attention in the next chapter. 

Even capital which is embodied in capital goods that 
are capable of reduplication may at any given time vary 
widely in productivity from establishment to establishment 
or from industry to industry. It is only by experimentation 
that the actual productivity of capital can be determined; 
and owing to the changing character of modern industry 
the process of experimentation must go on without ceasing. 
Accordingly there are always chances of mistakes in invest- 
ments. A cotton manufacturer may overestimate the pro- 
ductivity of capital in a given type of loom ; after purchasing 
and installing the machine he must content himself with 
what it will produce, even though he knows that the same 
amount of capital would in another form yield a far higher 
return. Cotton manufacturers as a class may overestimate 
the future demand for cotton goods, and so may be led to 
invest heavily in buildings and machinery which prove 
incapable of returning the normal rate of interest on capital. 
At the same time the shoe industry may be undersupplied 
with capital ; for a time, at least, every one hundred dollars 
invested in the industry may yield an abnormally high 
return. 

Such disparity in the productivity of capital in the two 
industries would, however, tend to disappear. The capital 
invested in new cotton mills would, of course, be fixed in the 
industry for a long period of time. But in the industry as 
a whole there are always some mills that are about to be dis- 
mantled, having reached the limit of their useful existence. 
These mills have presumably earned in the past a sum suffi- 
cient to replace themselves with new mills of a value equal 
to that of the original ones. If the cotton industry is suf- 



INTRODUCTORY ECONOMICS 1^3 

fering from a depression while the shoe industry is highly 
prosperous, the replacement fund will be diverted to the 
latter industry. Through the reduction of capital in the 
cotton industry the productivity of capital in that field is 
increased ; through the increase of capital in the shoe indus- 
try the productivity of capital is reduced in that industry. 
It is easy to see that if this process continues for any 
length of time the original disparity in productivity must 
disappear. 

The equalization of productivity is hastened by the dis- 
position of new accumulations of capital. The fund of 
capital, under modern conditions, is constantly growing in 
magnitude; consequently industries are, as a rule, expand- 
ing. The new capital naturally seeks the most productive 
fields. If, therefore, the rate of return in the cotton indus- 
try is abnormally low while that in the shoe industry is 
abnormally high, the new capital will avoid the former 
industry and seek investment in the latter. The influx of 
new capital into the shoe industry reduces productivity 
there, until at last capital is no more productive in the one 
industry than in the other. When this point has been 
reached further additions to the supply of capital are 
divided impartially between the two industries, reducing 
productivity uniformly. 

It is, of course, possible that the productivity of capital 
in the two industries may never be absolutely equal. While 
the tide of new capital is setting steadily toward the shoe 
industry a new demand for cotton goods or a new method 
of manufacture may appear and raise the productivity of 
capital in the cotton industry above that of the shoe industry. 
Some time will elapse before the change in the relative posi- 
tions of the two industries is generally known ; in the mean- 
time the flow of new capital into the shoe industry con- 
tinues. Eventually the new capital is diverted to the cotton 
industry ; it may continue to flow in that direction after the 
cotton industry has lost its relative superiority. We can 



174 INTRODUCTORY ECONOMICS 

only say that a tendency toward equalization of produc- 
tivity exists; not that the tendency is ever exactly realized. 

Our imaginary case will illustrate very well what is 
actually taking place in industrial society. Only, instead of 
two industries between which adjustment is to be made, we 
have thousands, big and little. Accordingly the chances of 
realizing absolute equality are far more remote. It may at 
first appear that the chances are so very remote that the 
tendency toward equalization of productivity is more or 
less mythical. The owner of new capital, we would all 
admit, wishes to place it where it will be most productive. 
But how can he acquaint himself so well with our bewilder- 
ingly complex industrial system that he will be able to 
search out the most productive opportunities for invest- 
ment? Suppose that a physician saves $i,ooo from his cur- 
rent income. Should he invest it in steel or cottons, or 
should he seek out some minor industrial field — straw-board 
or bicycle tires ? In all probability he knows little or nothing 
of the actual possibilities of any one of these fields of 
investment. 

If we examine the process by which new capital actu- 
ally finds its way into the various industrfes we shall find 
that this difficulty is not a very serious one. To a large 
extent, those who are already engaged in an industry, and 
consequently know most about it, act as agents for the 
investment of new capital. If an iron master believes that 
he can make additional capital yield eight per cent, he will 
be ready to borrow capital so long as it can be had for a 
little less than eight per cent. If the cotton manufacturer 
doubts that he can make capital produce more than five per 
cent., this is the maximum that he will pay for loanable 
capital. If then the supply of loanable capital is limited — 
and it always is limited — those industries promising the 
highest returns will bid a little higher for it, and draw it 
away from the industries yielding low returns. All that the 
investor has to do^ in order to place his capital in the more 



INTRODUCTORY ECONOMICS 1/5 

productive fields, is to accept the highest rate of interest he 
can get. 

But not all new capital finds its way into industry 
through loans. Some of it originates in the very industries 
that are expanding, and is directly invested by the income 
recipient. Some of it, though originating outside of the in- 
dustry, is invested without the agency of an intermediate 
borrower. Thus a new joint stock company may be launched 
in the cotton industry. Its capital is obtained through the sale 
of stock and the buyers of this stock are probably of divers 
trades and professions. Each purchaser of stock is nomi- 
nally investing on his own responsibility. But those invest- 
ors who know nothing of the business, unless they are very 
reckless, do so only after they have found that men who do 
know something about the business consider it a profitable 
venture. 

It is, of course, to be remembered that the productivity 
of capital is not the only thing that an investor takes into 
account in deciding in what industry he shall invest his sav- 
ings. In some investments the danger of losing all or a part 
of the capital invested is great. Capital employed in devel- 
oping the asphalt deposits of Venezuela may be highly pro- 
ductive. But there is a chance that the existing government 
of Venezuela, from which title to the asphalt deposits is 
derived, may be overturned, and a new government may 
confiscate the capital invested in the business. Capital 
invested in street railways in the lesser cities may be very 
productive. But if those cities do not follow a consistent 
policy in chartering new companies, it is possible that at any 
time rival lines may be established on parallel streets and, 
if unable to make large returns themselves, they may, 
nevertheless, reduce the return on capital invested in the 
original lines to almost nothing. The capital still remains 
in the possession of the investor, but it is "dead capital." A 
merchant's capital, invested in a fancy fabric, may promise 
high returns ; but a sudden change in fashion may force the 



176 INTRODUCTORY ECONOMICS 

merchant to sell the goods at a price which not only yields 
no return on the capital invested, but which entails an 
actual impairment of the capital fund itself. 

Some risk, it is plain, inheres in every business ; in some 
fields of investment, however, the risk is so small as to be 
negligible, while in other fields no prudent investor can dis- 
regard it. Other things equal, the vast majority of investors 
will prefer to invest in the safer fields. A disproportionately 
large share of the capital of society therefore seeks the 
safer investments, and as a result the productivity of capital 
in such investments falls below the rate of return to capital 
in the more hazardous investments. And thus it is that 
there appears a regular variation in the productivity of capi- 
tal corresponding with variations in risk. 

It is, of course, clear that it is not actual risk, but esti- 
mated risk that affects the distribution, and hence the pro- 
ductivity of capital. It is quite possible that the risk of 
losing capital invested in real estate in Texas is less than 
the risk of losing capital similarly invested in New York. 
But if most of the persons having capital to invest mis- 
takenly believe that the reverse is true, a disproportionately 
large part of the flow of new capital will enter the New 
York investment field and reduce the productivity of capital 
there below the level prevailing in Texas. 

In an earlier chapter we saw that risk affected wages 
only in so far as it affected the distribution of labor ; further, 
that if enough reckless workmen can be found to man the 
dangerous trades risk will not affect wages at all. Exactly 
the same thing is true of capital. If there were enough 
investors who always chose the more remunerative employ- 
ments for capital, regardless of risk, the hazardous fields 
would soon be so well supplied with capital that they would 
yield no higher returns than the safer ones. As a rule, how- 
ever, capital is far more timid in assuming risks than labor. 
It is therefore more anomalous to find capital in a haz- 
ardous field yielding only normal returns than it is to 



INTRODUCTORY ECONOMICS 177 

find workmen in dangerous occupations receiving only 
normal wages. 

Risk, then, may be regarded as a barrier which pre- 
vents capital from flowing freely into some of the more 
productive fields. It is of course not the only natural bar- 
rier affecting the flow of capital. If a particular industry is 
subject to the universal moral disapproval of a community, 
most capitalists will refuse to invest in it. Those who are 
unscrupulous enough to do so may enjoy the high returns 
that flow from an industry that is under-supplied with capi- 
tal. Thus high returns are often obtained from capital 
invested in gambHng dens and opium "joints." It is, of course, 
possible that the investment institutions of a country may 
be of such a nature that a man can hold stock in disrepu- 
table enterprises without the knowledge of his associates, 
and that investors who have no personal scruples are 
numerous. Under these conditions the productivity of capi- 
tal in such ventures will eventually fall to the normal level. 

It has been said above that those who are already 
engaged in an industry, and who have invested their own 
capital in it, serve as agents for investing in that field the 
capital of outsiders. But the appearance of the new capital 
reduces the productivity of that which was originally 
invested in the industry. Thus it appears that the original 
investors serve as agents for reducing their own incomes. 
This they do only because of divided interests — competition. 
Each enterpriser in an unusually productive industry who 
can borrow capital at a rate of interest which is less than 
the productivity of capital in his business can for a time 
increase his total income by doing so. The effect of similar 
action on the part of all the other enterprisers in the indus- 
try is to reduce the productivity of all the capital in the 
industry, including, of course, that of the capital originally 
employed in the field. If all the enterprisers were to act 
together, it is easy to see that they might find it to their 
advantage to check the influx of new capital before the 



178 INTRODUCTORY ECONOMICS 

productivity of capital in the industry reached the normal 
level. 

This in fact a monopoly does. Controlling all the 
Opportunities that an industry represents, it takes pains to 
limit the entire amount invested in such a w^ay that each 
unit of capital remains highly productive. New capital is 
thus turned away from the fields controlled by monopolies, 
and is forced into the fields where the productivity of capi- 
tal has already reached a comparatively low level. 

We may now sum up the foregoing discussion in the 
statement that the rate of interest on capital embodied in 
reproducible capital goods tends, in any industrial field, to 
equal the productivity of the capital thus embodied which is 
least essential to the economic exploitation of the field ; and 
further that there is a constant tendency toward equalization 
of productivity and of interest among the several fields of 
economic activity. If there were no barriers impeding the 
free action of competition and if changes in economic con- 
ditions were sufficiently gradual to permit of complete 
adjustment of the social fund of capital to the opportunities 
for its investment, the rate of return to capital would 
eventually be uniform throughout industrial society. Under 
such circumstances we should say that the rate of interest 
on capital is determined by the productivity of that capi- 
tal which is least essential to the business of society; in 
other words by the marginal productivity of social capital. 

The term interest is often used in a narrower sense, 
namely, to designate payments for borrowed money or capi- 
tal. We may consider briefly the laws governing such pay- 
ments. In former times loans were largely confined to 
advances to persons who desired to increase present con- 
sumption, with the more or less vague hope of obtaining 
sufficient means in the future to cancel the obligations thus 
created. Thus the heir presumptive to a landed estate 
often had dealings with usurers, who advanced the means 
of present luxurious living. It would be difficult to estab- 



INTRODUCTORY ECONOMICS 1 79 

lish a law governing the rate of interest on such loans. It 
varies from one case to another according to the necessities 
and improvidence of the borrower and according to the 
greed and cunning of the lender. 

In the typical loan transaction of to-day money is bor- 
rowed for the purpose of increasing one's equipment of 
capital goods. What is really borrowed is capital. The 
laws governing the rate of interest on such loans lend them- 
selves readily to scientific formulation. 

Let us suppose that in a certain community there are 
some business men who can make additional capital yield 
ten per cent. Of course they cannot employ an unlimited 
amount of capital in such productive investments. But 
perhaps they can make an aggregate sum of $100,000 return 
a rate of ten per cent. An additional $100,000 they might 
be able to invest in such a way as to yield nine per cent. 
Other business men, less favorably situated, might perhaps 
be able to make another $100,000 yield nine per cent. 
These two classes together might be able to use $300,000 
more in investments yielding eight per cent., and a third 
class of business men might be able to invest $200,000 more 
at this rate. Now, if the entire supply of loanable capital 
is limited to $100,000, it is clear that the interest on such 
capital must be above nine per cent. Otherwise the men 
enjoying the most productive opportunities for investment 
would see the men having less productive opportunities 
securing part of the supply of capital. Indeed, the rate must 
be very near ten per cent., as the men having the best oppor- 
tunities will compete among themselves for the limited sup- 
ply and so force the rate up. If the supply of loanable 
capital is more than $100,000, but less than $300,000, the 
rate on all the capital would, for similar reasons, be nine 
per cent. If the supply of such capital exceeds $300,000, 
but is less than $800,000, the rate would be eight per cent. 
We may state the principle involved in the following terms : 
The rate of interest paid on loanable capital tends to equal 



l8o INTRODUCTORY ECONOMICS 

its productivity in the hands of the business men who enjoy 
the least favorable opportunities for investment, but whose 
demand is, nevertheless, necessary to carry off the entire 
supply of such capital. 

It is furthermore clear that the rate of interest on 
loanable capital must in the end very nearly coincide with 
the rate of interest on capital directly invested by its owner. 
If the rate on loans is less than that on direct investments, 
many who now lend their capital will become direct invest- 
ors. If the rate on loans is relatively high, many who now 
invest directly will wind up their business and become 
lenders of capital. 

It must of course be understood that in so far as capi- 
tal directly invested is more than normally productive on 
account of the hazardous nature of a business, a discrepancy 
between the loan rate and the direct rate will persist. When 
losses occur they fall ordinarily on the capital directly 
invested. Until a business man's own capital is entirely 
wiped out he must pay his obligations to the lender in full. 
Thus the business man's own capital serves to insure the 
maintenance of the borrowed capital ; and the business man 
naturally deducts a part of the return to the borrowed capi- 
tal and keeps it for himself, assigning it to his own capital. 
If such insurance is inadequate, a part of the extra product 
is transferred to the lender in the form of high interest. 
Thus the returns to loanable capital vary somewhat, accord- 
ing to degree of risk, but naturally not in the same degree 
as the returns to capital directly invested. 

Again, if capital is abnormally productive in a given 
industry on account of the existence of a monopoly, this 
does not profit the lender. The Standard Oil Company 
may perhaps be able to make capital yield twenty per cent, 
but if it borrows money it pays only four or five per cent. — 
whatever the market rate may be. The extra product is 
retained by the monopoly and assigned to the capital 
directly invested. 



CHAPTER XIII 
Rent and Capitalization 

In popular usage the term rent is applied to any pay- 
ment which one person makes to another for the temporary 
use of a concrete capital good or group of goods. Thus 
rent may be paid for the use of a farm, a house, a piano, a 
square yard of advertising space on a bill board. In the 
nature of the case, only those things can be rented which 
remain practically intact through the period of use. One 
never rents a bin of coal or a stock of merchandise. Nor 
does one ever rent goods which can serve their purpose 
only by entering into permanent combination with other 
capital goods. No one would think of trying to rent steel 
beams to be used in the construction of his house. The 
more nearly indestructible a capital good is, and the more 
perfectly it yields up its services without losing its identity, 
the better is it adapted to the renting contract. Thus a field, 
being practically indestructible, may very well be rented for 
a period of years, although if its cultivation requires the 
incorporation of a large amount of auxiliary capital in the 
soil, in the form of drains or irrigation ditches, the field and 
the auxiliary capital must usually be rented together. A 
piano, which is much more likely to be injured, nevertheless 
lends itself readily to the renting contract because no other 
capital good enters into permanent combination with it in 
use. 

In economic discussion the term rent may properly be 
given a more general application. If a man owns and 
manages a farm which he could let at a rental of $i,ooo, we 
may say that $i,ooo out of his income is really the rent of 
his farm. True, he does not pay this sum to any one ; but 
neither does he pay any one wages for the labor which he 



1 82 INTRODUCTORY ECONOMICS 

himself performs. It would be absurd, however, to say- 
that a man earns no wages when he is working for himself. 
As employer he pays himself wages as workman. In like 
manner, the man who cultivates his own field may be thought 
of as paying rent, as cultivator, to himself, as landlord. So, 
if an ocean transportation company owns and sails a ship 
which it could let for $5,000 a year, we may regard $5,000 
out of the proceeds of the company's business as the rent 
of this particular ship. In this broad sense of the term, 
rent may be defined as that part of the proceeds of a busi- 
ness which is economically due to a particular capital good. 
It is the economic product of a capital good, regarded as a 
lump sum. And as even the most perishable of capital 
goods yield a product which may be measured in this way, 
we may strain the ordinary meaning of the term rent so as 
to include the concrete products of all capital goods 
whatsoever. 

We must be careful to distinguish between the total 
product of a capital good, or its gross rent, and that part of 
the product remaining after the cost of depreciation of the 
capital good has been deducted, or net rent. To arrive at 
the net rent of a house we must deduct from the gross rent 
a sum sufficient to meet the cost of repairs, together with a 
year's proper contribution to a fund for the replacement of 
the house when it shall cease to be habitable. Even the pay- 
ment for the use of a field is a gross rent. The field wears 
out — that is, it loses through cropping a part of its original 
or acquired fertility. The owner of the field must, there- 
fore, set aside a part of the product of the land to restore 
the fertility of the soil. 

While the term rent is, as has been said, properly 
applied to the product of any concrete capital good, we shall 
in this chapter confine our study to the rent of those classes 
of goods that are of such a nature as to permit the trans- 
fer of their uses under renting contracts. The distinguish- 
ing characteristic of this class of goods is that the capital. 



INTRODUCTORY ECONOx\IICS 1 83 

embodied in them is fixed there, for a considerable period 
of time at least. It takes perhaps ten years before the 
capital invested in a boat can migrate to some industry upon 
the dry land. The capital embodied in a well-built house 
may be fixed there for fifty years; and the capital invested 
in a field, in a tunnel or in an excavation must remain where 
it is forever. It is true that you may take your capital out 
of a field; this you do v/hen you sell it. But what you 
really do when you sell the field is to transfer your claim to 
the capital it represents to another person. The capital in 
the field is the same after the transaction as it was before it. 
Such permanently invested capital may be contrasted with 
the capital invested in transitory forms, as coal, raw 
materials, merchants' stocks. The capital invested in these 
forms returns to its owner in a relatively short time in the 
form of purchasing power, and may be reinvested in any 
one out of a thousand different classes of capital goods. The 
return to such transitory goods is most conveniently calcu- 
lated as a percentage return to the capital invested in them. 
It is natural to think of the return to a farm or a building 
as a certain sum of money, or a rent. One may, of course, 
translate the rent into terms of interest on the capital 
invested in the farm or building. On the other hand, it is 
natural to think of the return to a merchant's stock in trade 
as interest on the capital invested in the stock, although it 
would be quite possible to arrive at the returns to the stock 
by adding together the net products of all the capital goods 
whose services have been used. It will be noted that net 
rent, in the sense in which the term is used here, is 
nothing but interest under another form. Reduce the rent 
to a percentage of the capital value embodied in the 
goods which produce the rent, and what you have is 
interest. 

In an earlier chapter we saw that there are two ways of 
arriving at the product of a concrete capital good, or its 
rent. One way is to withdraw the capital good from the 



I(S4 INTRODUCTORY ECONOMICS 

productive combination into which it enters, noting the 
shrinkage in product that follows. The other way is to 
deduct from the gross receipts from a group of several 
goods the shares (if these can be independently ascertained) 
that are due to all of the goods except one. What is left 
is of course the product of the remaining good. Either 
method may be employed in ascertaining the rent of many 
capital goods; but the latter method is most frequently 
employed in the case of goods that lend themselves readily 
to the renting contract. If one wishes to rent a steam 
thresher, for example, he will first of all inquire what the 
gross earnings from the operation of the machine are likely 
to be. Perhaps such earnings will average $20 a day. In 
order to operate the thresher, it is, of course, necessary to 
employ labor and auxiliary capital goods — as coal and 
machine oil — in connection with it. The labor must be paid 
for at the prevailing rate of wages; coal and oil must be 
paid for at the market price. There are accordingly definite 
sums that must be deducted from the gross receipts from 
the operation of the machine. Whatever is left after these 
charges have been met — possibly $10 — is the gross rent of 
the machine for the day. 

In the foregoing example the cost of labor and of coal, 
etc., are regarded as preferred charges upon the earnings of 
the enterprise, and this indeed they are. The operator of 
the threshing machine must pay at least the prevailing rate 
of wages, or he cannot get labor to run the machine at all. 
Similarly, he must pay the market price of coal. Labor and 
coal have a multitude of uses outside of the business of 
threshing ; if not properly rewarded in that business they go 
elsewhere. The machine, on the other hand, cannot seek 
other employment. It is committed to a particular function ; 
consequently it cannot enforce any claim for a specific 
remuneration. The machine is, as it were, a residuary 
claimant. And this is more or less true of most of the 
capital goods that are actually rented. Economists there- 



INTRODUCTORY ECONOMICS 1 85 

fore find it convenient to treat rent as though it were always 
determined in this way. 

A steamship building company, not having sufficient 
orders on hand, launches a freighter on its own account, 
trusting to the chance that some ocean transportation com- 
pany will be ready to pay a fair rental for its use. What will 
determine the rent that the transportation company will 
offer to pay? The managers of that company can probably 
estimate pretty accurately what the gross receipts from a 
year's operation of such a ship would be. Let us say that 
the estimated gross receipts are $25,000. From this sum 
must be deducted the wages of officers and men, $7,000; 
charges for pilotage, harbor dues, etc., $1,000; the cost of 
coal and provisions, $10,000; miscellaneous expenses, 
$1,000. Nor is this quite all. The $10,000 invested in coal 
and provisions— supposing that the transportation company 
must purchase the whole amount at the beginning of the 
year — is capital that would in any other field earn $500 
interest. This sum must therefore be added to the pre- 
ferred charges of operating the ship. The $5,500 remain- 
ing out of the estimated gross receipts is the maximum 
rent that the transportation company can pay for the 
use of the ship. This sum, the gross rent of the 
ship, includes, however, payment for the depreciation of 
the ship through one year's use. If this amounts to 
$1,000 we have remaining the sum of $4,500 as the 
net rent. 

Similarly the gross rent of a farm is found by deducting 
from gross receipts a sum that is sufficient to pay the wages 
of all labor employed in cultivating it ; to replace all capital 
goods used up; to keep up the efficiency of all stock and 
machinery, together with interest at the prevailing rate on 
the capital invested in such movable capital goods. To 
arrive at the net rent we must deduct from the gross rent 
thus determined whatever may be necessary to keep build- 
ings, fences, etc., in repair and to restore to the soil any ele- 



1 86 INTRODUCTORY ECONOMICS 

ments of fertility that have been destroyed in the year's 
cropping. 

In the cases that have been cited the rent-yielding object 
was a group of capital goods, more or less securely bound 
together in use. The farm, for example, may be analyzed 
into several distinct factors. One factor in the group is the 
bare land; another factor consists of improvements merged 
in the soil, as drains or irrigation ditches; a third factor 
consists of farm bulidings, fences, tree plantations, etc. 
Some part of the rent must be ascribable to each one of 
these factors. The productivity of such a factor cannot be 
found by withdrawing it; nor can it be found by treating 
it as a residue, after ascertaining the shares of the other 
factors combined with it, for these shares cannot be ascer- 
tained directly. There remains the method of comparisons. 
How much more will a well-drained field yield than another 
field in the vicinity, of apparently equal natural fertility, 
but without drains ? By such comparisons it is usually pos- 
sible to tell pretty nearly what each factor in a permanent 
combination of capital goods is producing. One may dis- 
tinguish in this way between the rent paid for a city house 
and the rent paid for the ground it stands on, although the 
two rents usually make parts of a single payment. Find an 
equally spacious and costly house in a suburb, where a 
building lot is to be had for practically nothing. The differ- 
ence in the rent of the two houses is a fairly accurate mea- 
sure of the rent of the city lot. 

The rent of a ship, a building or a machine, may, as we 
have seen, be ascertained, in the first instance, by subtract- 
ing from the gross receipts arising from its operation a sum 
covering all other expenses connected with its use. The 
value of such a rent-bearing object does not immediately 
affect the amount of rent it yields. A ship that yields a net 
surplus of $5,000 above operating expenses may be worth 
$50,000 or $100,000. The value of the ship has nothing to 
do with the amount of rent that its owner will receive in the 



INTRODUCTORY ECONOMICS 187 

immediate future. But a ship is a capital good that requires 
periodic renewal. Out of i,ooo ships sailing the ocean to-day 
probably fifty are near the end of their economic existence, 
and will have to be replaced by new ships if the existing ton- 
nage is to be maintained. Now, if the rent of ships happens 
to be so low as not to pay the ordinary rate of interest on 
the capital invested in them, no new ships will be built to 
take the places of those that are no longer seaworthy. The 
aggregate tonnage will thus be reduced; freights will be 
advanced until the rent of ships rises to a figure which 
affords a normal return to shipping capital. If, on the other 
hand, the rent of ships represents an abnormally high return 
to capital, more ships will be built, and freights will decline 
until the rent of ships is only sufiicient to pay a fair rate of 
interest on the capital invested in them. And this is in gen- 
eral true of the rents of all capital goods requiring periodic 
renewal. For a time the rent may be too high or too low to 
afford just a normal return to the capital invested in such 
goods. In the long run, however, the rent is controlled by 
the prevailing rate of interest. 

We have seen how it is possible to distinguish the rent 
of the bare land from the rent of the improvements fixed in 
it. The rent of the land as such is practically of more 
importance than the rent of any other class of capital goods, 
as land is more frequently held under lease than any other 
class of capital goods. For this reason, and because land 
rent displays certain peculiar characteristics, it is worth 
while to devote especial attention to a study of the laws 
determining it. This does not mean that we should follow 
the earlier economists in treating ground rent as a peculiar 
form of income, to be sharply distinguished from all other 
rents. 

Let us assume that the construction of a railway throws 
open to exploitation a large section of territory in the British 
Northwest, and that all the land is at once bought up by 
wealthy persons who intend to hold it permanently, par- 



l88 INTRODUCTORY ECONOMICS 

celing It out in tracts suitable for tenant farmers. We shall 
further assume that the owners of the land leave its equip- 
ment with auxiliary capital goods entirely to the tenants, 
and that the deterioration of the land is so slight as to be 
negligible. Whatever the tenant can be made to pay, under 
these conditions, is practically the rent of the bare land. 

In making up his bid the tenant will have to estimate, 
on the one hand, the gross receipts from the land which he 
expects to occupy, and, on the other hand, all expenses of 
cultivation, including the wages of all labor employed, his 
own as well as that of hired hands ; interest on the auxiliary 
capital which he furnishes, whether his own or borrowed 
capital; and a sum sufficient to replace or repair capital 
goods destroyed or impaired through use. Let us suppose 
that all these items of expense amount to $i,ooo. If the 
tenant has reason to believe that one year with another the 
gross receipts from the farm will be only $i,ooo he will pay 
nothing at all to the owner of the land for its use. If on the 
other hand he believes that the gross receipts will be $2,000 
he will be prepared to pay a rent of $1,000. 

It is obvious that what the tenant can afford to pay for 
the use of the land depends, in large measure, upon the 
rates at which he must reckon the wages of labor and inter- 
est on auxiliary capital. If these rates are high the deduc- 
tions from gross receipt's to be made in calculating rent will 
be large. Accordingly, in order to arrive at the forces de- 
termining the rent of land in the section which we are study- 
ing, we must examine the influences affecting the local rates 
of wages and interest. 

Land in the Canadian Northwest, as in every other part 
of the world, varies in natural fertility and in accessibility. 
If the supply of auxiliary capital and of labor is very small, 
only the most fertile and most accessible lands will be culti- 
vated at all. The owners of slightly poorer or slightly less 
accessible lands will of course derive no revenue from them ; 
they could afford to let such lands for a nominal rent. On 



INTRODUCTORY ECONOMICS 189 

these lands, then, labor and auxiliary capital are free to 
divide between them whatever they can produce. The labor 
and auxiliary capital employed on the better land can 
demand at least as much for themselves; if this is refused 
they will migrate to the unoccupied fields. 

Now let us suppose that a new body of laborers, bring- 
ing with them the appropriate auxiliary capital, enter the 
region. These occupy the lands which in fertility and acces- 
sibility are least inferior to those first cultivated. If after 
this accession of labor and capital any one is dissatisfied 
with wages on the better lands, he may, as before, migrate 
to land still remaining unoccupied. But the unoccupied 
land is now more remote and less fertile than was that exist- 
ing before the accession of new labor and capital, and the 
product of labor and capital on such lands will be less. The 
cultivator of the better grade of land v/ill, therefore, not 
have to pay so much for either factor as before. A larger 
share of his gross receipts may therefore be paid out in rent. 
And with every increase in the labor and auxiliary capital 
of the community, remoter and less fertile lands are brought 
under cultivation, with consequent decline in wages and in 
interest on auxiliary capital, and increase in the rent of all 
the better grades of land. At any particular time we may 
say that in this community the wages of labor and the inter- 
est on auxiliary capital are determined, respectively, by 
the productivity of labor and of auxiliary capital on the 
poorest land actually cultivated. This is of course only 
a special instance of the law stated in earlier chapters, 
that wages and interest are determined by marginal prod- 
uctivity. 

If we exclude from our consideration the relation of the 
community which we are studying with the rest of the 
world, we may say, as did the classical economists, that the 
rent of any piece of land is the difference between the value 
of what is produced on that land and the value of what can 
be produced by an equal amount of labor and auxiliary 



IQO INTRODUCTORY ECONOMICS 

capital on the poorest land actually in cultivation. But we 
cannot suppose that any such community will long remain 
unrelated with the rest of the world. If the wages of labor 
in the community are higher than the wages of similar 
labor in older centers of civilization, population will increase 
through immigration; poorer and poorer lands will be 
brought under cultivation ; the wages of labor will fall, until 
there is no longer special inducement to immigrate. In a 
similar manner capital for investment in agricultural stock 
will flow into the community so long as the rate of interest 
is above the rate prevailing elsewhere. Thus the ultimate 
forces controlling wages of labor and interest on auxiliary 
capital are the forces that determine the rewards of these 
economic factors in the industrial world at large. General 
wages and interest are determined, we have seen, by the 
marginal productivity of labor and capital, respectively, not 
only in agriculture, but in manufactures, mining, transpor- 
tation, and all other fields of economic endeavor. And as 
the productivity of labor and auxiliary capital in the general 
economic field increases or diminishes, the shares of these 
agents in our imaginary community increase or diminish. 
The rent of land, in the community, increases as these shares 
diminish and decreases as they increase. 

From the fact that when labor and capital flow into a 
new region the rent of land steadily rises, it is often assumed 
that the aggregate of land rents is constantly increasing. 
But it is to be borne in mind that when labor and capital are 
drawn into a new region, the older communities may come 
to be less fully supplied than before. And this would in- 
crease the shares of labor and of auxiliary capital in those 
communities, and reduce the share that is assigned to land. 
The increase in rents in America, in the last half century, has 
in some measure been offset by a decline in rents in Europe. 
If, however, population and capital in reproducible forms 
continue to increase, without any corresponding increase in 
the amount of land accessible to the cultivator, and without 



INTRODUCTORY ECONOMICS I9I 

improvements that increase the general productivity of labor 
and capital, the aggregate of land rent must increase. 

In the foregoing example we have assumed that the 
value of the product of a farm remains fixed, while the rates 
of wages and interest vary. Let us now see what would be 
the effect on rent of an increase in the value of the product — 
which we shall assume to be wheat. Such an increase might 
be brought about by a reduction in the cost of transporta- 
tion. For the local price of wheat is practically equal to the 
price in England, the great wheat market of the world, less 
cost of transporting the wheat thither. If the cost of trans- 
portation is reduced five cents a bushel, the local price of 
wheat will rise five cents a bushel. 

If the growers of wheat are forced to rely upon the 
local supplies of labor and capital the efifect of the rise in the 
price of wheat will be an increase in wages of labor and 
interest on auxiliary capital; the rent of land will scarcely 
be affected at all. For under the conditions assumed, wages 
and interest are determined by the value of the product of 
these agents on the poorest lands in the community actually 
in use. The value of this product will be increased by the 
rise in the price of wheat ; hence wages and interest will rise 
throughout the territory. The cultivator will have greater 
gross receipts, but he will have greater deductions to make 
under the heads of wages and interest. There is no reason 
why the surplus, or land rent, should rise at all. 

If on the other hand close relations have been estab- 
lished between this region and the rest of the world, so that 
wages and interest are determined by the general influences 
prevailing in society, practically the whole of the advance in 
wheat prices will be applied to rent. For suppose that at 
first wages and interest are raised above the general level. 
Additional labor and capital will flow into the region ; com- 
petition will arise for employment on the better lands, or 
worse lands will be put under cultivation. Thus the mar- 
ginal productivity of labor and of auxiliary capital will be 



19^ INTRODUCTORY ECONOMICS 

reduced and the rent of land will increase, until labor and 
capital are rewarded no better than they were before — that 
is, until land rent has absorbed the entire benefit of the 
increase in price. It is true that the withdrawal of labor 
and capital from the general field that this movement implies 
will tend to raise the rewards of these agents slightly. But 
this influence will be hardly perceptible. 

We can now understand what it is that forces up rents 
in the vicinity of a growing city. The value of the gross 
product of a given area is constantly increasing, as a result of 
increased demand, while the charges to be deducted, wages 
and interest on capital in reproducible forms, are controlled 
by general laws which are affected only slightly, if at all, by 
the growth of this particular city. Similarly with the rent 
of city lots. The aggregate profits from the business that 
may be transacted on a given ground space increase with 
the growth of a city, and as wages and interest on repro- 
ducible capital do not increase in equal degree, a larger sur- 
plus is left for the owner of the land. It is obvious that the 
same Reasoning will apply to the rent of a railway or a canal 
in a rapidly developing region. The route of railway or 
canal is a capital good which cannot readily be reproduced. 
Accordingly, if the aggregate business to be carried on 
increases, an increasing share of the value product of the 
business will take the form of rent on the irreproducible 
elements. 

In all the cases that we have examined, an important 
factor in raising rents of land and similar capital goods is 
the influx, or possibility of influx, of capital and labor from 
the general field. If we view society as a whole, there is, of 
course, no possibility of a similar influx of labor and capital 
from outside regions. Nothing can transfer to the owners 
of land the benefits of increased value product except 
increase in the aggregate supply of labor and auxiliary capi- 
tal. If these agents remain stationary in quantity, while the 
progress of improvements raises the productivity of those 



INTRODUCTORY ECONOMICS 193 

units placed at the greatest disadvantage — ^that is, if general 
wages and interest rise — it is obvious that the rent of land 
may fall. So also if population and auxiliary capital de- 
crease in amount. If, on the other hand, labor and auxiliary 
capital increase so rapidly that wages and the interest on 
such capital fall, land rents must in general rise. It is of 
course possible that increase of capital and of labor may be 
attended by such great improvements in methods of produc- 
tion that wages, interest on reproducible capital goods, and 
land rent will all increase. This has been more or less true 
of the economic development of the last century. 

The net rent of a concrete capital good, as has already 
been indicated, is nothing but the interest on the capital 
invested in that capital good, expressed in the form of a 
lump sum. It is accordingly natural that payments which 
figure in one man's accounts as rent often figure in the 
accounts of another man as interest. A business man may 
count as rent the $10,000 he pays for the use of a store build- 
ing; the owner of the building may regard the same pay- 
ment as interest on the capital invested in the building. The 
business man may have his choice between paying $5,000 a 
year for the building, or becoming the nominal owner, 
giving his note for $100,000 at five per cent, interest. In 
the latter case he regards his annual payment of $5,000 as 
interest, not rent. Obviously, whether the payment is called 
interest or rent is rather a matter of legal form than of 
economic essence. 

Given the net rent of a capital good, and the current 
rate of interest on capital, it is an easy matter to ascertain 
the amount of capital invested in the good. This process 
of computing the capital through the net rent is known as 
capitalization. If a building earns $10,000 a year, and there 
is good reason for believing that it will continue to earn the 
same net rent indefinitely, the simplest way of ascertaining 
how much capital is invested in the building is to find how 
large a sum of capital, in general investments, is required to 



194 INTRODUCTORY ECONOMICS 

earn an equal sum. If the general rate of interest is teti 
per cent., this sum will be $100,000. If the rate of interest 
is five per cent., the sum will be $200,000. In the one case 
the rent is capitalized at ten per cent. ; in the other case at 
five per cent. 

In the case of reproducible capital goods, the net rent 
alone is no sufficient indication of capital value. The cost 
of producing similar goods must be taken into account; 
indeed, this is by far the more important element in the com- 
putation. A ship, for example, may yield a net rent of 
$10,000 at a time when the current rate of interest is five 
per cent. It would, however, be a reckless business man 
who would assume, from these data, that the ship represents 
a capital of $200,000, and that he could afford to pay that 
sum for it. If a similar ship can be built for $100,000, this 
sum is the true measure of the capital invested. The net 
rent of $10,000 merely indicates that capital in ships is, for 
the time, highly productive. Soon the supply of ships will, 
doubtless, be increased and the net rent will fall to about 
$5,000. It may be a year before the decline will take place ; 
in that case the buyer of a ship already afloat can afford to 
pay about $105,000 for it. This sum may be analyzed into 
two parts : $100,000 for the capital in the ship, and $5,000 
for the transfer of the extra productivity of the ship through 
one year. If several years must elapse before the net rent 
of ships falls, the second element in the price of the ship 
will be placed at a higher figure. And if in some way this 
extra productivity could be made perpetual — if the ship, 
worth originally $100,000, could be made to yield indefi- 
nitely $5,000 in addition to the normal earnings of the capi- 
tal invested in it — ^the buyer could afford to pay as much 
for this extra product as for the original capital. That is, 
he would arrive at the value of the ship, not through a com- 
putation of its cost of production, but through a capitaliza-^ 
tion of its entire net rent. 

Now, a tract of land is a capital good in a situation 



INTRODUCTORY ECONOMICS 195 

analogous to that of the ship in our hypothetical case. The 
capital invested in the land, in the first instance, may have 
been nothing at all. But if the land yields a net rent of 
$5,000 a year, that fact is the only one that buyer or seller 
will need to consider. For it is not possible that the supply 
of similar pieces of land at the command of society will be 
so increased that the net rent will shrink to zero, as would 
be the case with a reproducible good originally costing 
nothing. Because of the natural limitation upon the supply 
of land, there is good reason for supposing that the existing 
rent will continue to be paid indefinitely. The right to re- 
ceive the $5,000 land rent for all time is therefore worth 
just as much as the possession of a capital in reproducible 
forms yielding $5,000 interest annually. If capital in repro- 
ducible goods yields, as a rule, ten per cent., the rent of the 
land will be capitalized at $50,000; if the current rate on 
such capital is only five per cent., the rent will be capitalized 
at $100,000. 

Shall we say that a tract of land that yields $5,000 rent, 
and is capitalized at $100,000, is really a capital of $100,000, 
or shall we say that the real capital in the land is only the 
sum originally employed to clear it and render it fit for 
economic use? If we adopt the former mode of expression, 
we shall regard the capital in the land as no more productive 
than capital in any other form. If we adopt the latter mode 
of expression, we shall regard the capital in the land as 
extraordinarily productive. Business men, and many mod- 
ern economists, adopt the former mode of expression. A 
property that yields regularly the income of a capital of 
$100,000 is a capital of $100,000. 

It matters little what mode of expression we employ so 
long as we bear in mind the fact that the value of the land 
is merely the capitalization of its rent at the current rate of 
interest; that with an increase in the rent of a given tract 
of land, if interest on capital in reproducible goods remains 
unchanged, the capital value of the land automatically 



196 INTRODUCTORY ECONOMICS 

increases, until the ratio of the capital value of land to its 
net rent is the same as the ratio of the capital value of a 
group of typical reproducible capital goods to their net rent ; 
that with a decline in the interest rate on capital in repro- 
ducible goods, the value of land yielding a given rent 
increases until the rate of interest on so-called capital in 
land is no higher than the rate of interest on other forms of 
capital. If the rate of interest on capital in reproducible 
capital goods falls, it is because the earning power of such 
goods declines. If the rate of interest on capital in land 
declines, it is usually because the land is revalued at a higher 
figure — that is, counts for a larger sum of capital. 

We have already seen that with increase in the social 
fund of reproducible capital the productivity of such capital 
declines ; the rate of interest falls, and a larger share of the 
product of society takes the form of ground rent. This of 
itself would have the effect of increasing the capital value 
of land. The decline of the interest rate affects the value of 
land further through changing the rate at which a given rent 
is capitalized. If the current rate of interest is ten per cent., 
a certain field may produce a net rent of $1,000. This sum, 
capitalized at ten per cent., gives a value of $10,000, which 
we may, if we choose, call the capital invested in the field. 
At the end of two decades the current rate of interest may 
have fallen to five per cent. This would naturally increase 
the rent of the field in question — perhaps to $2,000. This 
rent we must now capitalize, not at ten per cent., as for- 
merly, but at the new current rate of five per cent. The 
value of the land thus comes to be $40,000. 



CHAPTER XIV 

Business Profits 

In popular language the term "profit" is usually applied 
to the net earnings of a business — that is, gross receipts less 
actual expenses. These net earnings include the return to 
the capital that is contributed by the man in whose name the 
business is conducted, as well as his reward for the labors 
of management. Since political economy extends the mean- 
ing of the term "wages" so as to include the reward for the 
labor of management, and extends the meaning of the term 
"interest" so as to include the earnings of all capital, whether 
owned by the business man or not, the scope of the term 
"profit" must be correspondingly restricted. As the term is 
used in modern economic literature, it designates a surplus 
remaining after all costs, including interest on all capital 
and wages for all labor, have been met. 

Profit in this sense of the term forms no part of the 
income of the capitalist as such, for his claims are satisfied 
when interest is paid on his capital. It forms no part of 
wages. It is the proper income of the enterpriser — ^the man 
who employs both labor and capital in a business enterprise. 
What functions the enterpriser performs we must now 
consider. 

Let us suppose that a man of known integrity and busi- 
ness capacity decides to establish a manufacturing business. 
He may be able to borrow at a stipulated rate of interest all 
the capital that the enterprise requires. Having command 
of this capital, he proceeds to acquire a building and the 
appropriate equipment, and selects subordinates whose duty 
it is to secure the necessary office force and manual workers. 
The actual work of the business man himself may be a negli- 
gible minimum. His secretaries may collect the information 



198 INTRODUCTORY ECONOMICS 

on which he acts in deciding to found such a business. His 
attorneys may arrange the details of the loan contract; his 
banker may find for him the persons who have capital to 
lend. Even the business of selecting a building and choos- 
ing a responsible manager may be given over to salaried 
employees. What, then, is the connection of the business 
man with the enterprise? He lends it his name, he assumes 
legal responsibility for the conduct of the business, and he 
reserves to himself the ultimate power of approving or veto- 
ing proposals made by his staff. These are the only func- 
tions that the enterpriser must necessarily retain. 

In real life it would be difficult to discover a man who 
is an enterpriser and nothing more. It is rarely the case 
that a man without capital can borrow any considerable 
amount of it. Lenders demand the security that only the 
owner of independent resources can give. It would, more- 
over, be a fortunate enterpriser who could find secretaries 
and managers who can be trusted to the extent we have 
assumed. A part of the labor of oversight must ordinarily 
be performed by the business man himself. The fact that 
the same man combines in himself the functions of enter- 
priser, laborer and capitalist does not, however, make the 
functions indistinguishable. 

What we are concerned with in the present chapter is 
the nature of profit, the income of the enterpriser as such. 
Profit appears only when the selling prices of the products 
of an enterprise exceed the cost of those products. We may, 
therefore, study profit from the viewpoint of the forces 
determining prices. Or, we may study profit from the point 
of view of distribution, inquiring into the conditions under 
which wages and interest fail to absorb the entire net 
product of labor and capital. The latter will be the point of 
view of this chapter, as we have already approached the 
problem from the point of view of prices in the chapters on 
''Market Price" and "Cost of Production." 

If competition were all pervading and instantaneous in 



INTRODUCTORY ECONOMICS I99 

its action, every laborer and every unit of capital would 
receive precisely the product created by that laborer or unit 
of capital. Enterprisers would bid against one another so 
long as labor or capital received a reward inferior to the 
total value of the product of labor or of capital. Every 
laborer would produce a value equal to that produced by 
any similar laborer ; the product of all equal units of capital 
would be equalized. How this equalization of products 
would be realized we have already seen : through the move- 
ment of labor and capital from fields of low productivity to 
fields of high productivity. 

In the existing state of industry, however, competi- 
tion does not operate thus uniformly and effectively. There 
are circumstances under which enterprisers as a class hesi- 
tate to bid for additional labor and capital even when it 
would be profitable for any member of the class to do so — 
that is, when contract wages and interest are inferior to the 
product of labor and capital. Labor and capital, further, 
vary in productivity from locality to locality and from in- 
dustry to industry. There is accordingly a possibility that 
enterprisers may engage laborers at the rates prevailing in 
the employments of low productivity and set them at work 
in the employments of high productivity, retaining for them- 
selves a part of the increased product of the labor. Similar 
gains may be obtained through borrowing capital where its 
productivity is low and employing it in fields where its 
productivity is high. Again, certain laborers may be ab- 
solutely dependent upon a single enterpriser for their employ- 
ment ; certain capitalists may be under similar disabilities in 
the disposal of their loanable funds. In such cases, the enter- 
priser may fix rates of wages and of interest which do not 
correspond with the productivity of labor and capital. 
Profits arising from this source are comparatively unimpor- 
tant. They appear in such enterprises as are represented by 
the sweating trade. 

We may first examine the conditions under which en- 



200 INTRODUCTORY ECONOMICS 

terprisers as a class obtain a- profit through refraining from 
the competition that tends to force wages and interest to a 
level where they absorb the entire product of labor and 
capital. In times of so-called prosperity it often happens 
that, for reasons which are not generally understood, the 
prices of almost all commodities rise; or, what amounts to 
the same thing, the products of labor and capital, measured 
in terms of price, increase. For a time enterprisers fear 
that the rise in prices is a merely temporary phenomenon, 
to be followed, perhaps, by a fall of prices to a level lower 
than that existing before the rise. So long as enterprisers 
maintain this attitude, they naturally refrain from enlarg- 
ing their businesses. No enterpriser attempts to entice away 
the workmen in the employ of other enterprisers, as he 
would do if he believed that the high level of prices would 
be maintained, nor does he increase his demands upon the 
fund of loanable capital. There is accordingly no reason 
why wages and interest should rise. The effect of the rise 
of prices is thus to increase the price of the products of 
labor and capital without increasing the cost of labor or of 
the use of capital. If before the rise in prices labor and 
capital received the whole value of their products, it is ob- 
vious that they receive less than this after the rise. A part 
of the product of labor and of capital remains in the hands 
of the enterprisers as a profit. 

If the high prices are maintained for any length of time, 
one enterpriser after another decides to enlarge his busi- 
ness in order to increase his aggregate profits. He can do 
this only by enticing away some of the men employed by 
other enterprisers, through the offer of slightly higher wages. 
Those enterprisers, averse to losing their working force at 
a time of high profits, are compelled to raise wages them- 
selves. And thus a force is set in motion which will eventu- 
ally raise the cost of labor until it absorbs the whole value 
product of labor. Similarly enterprisers bid against one 
another for capital, thus forcing up the rate of interest until 



INTRODUCTORY ECONOMICS 201 

it absorbs the whole product of capital. Thus eventually 
the general profits of a period of prosperity disappear. 

It is a familiar fact that wages and interest vary greatly 
from locality to locality. A carpenter in Boston does not 
receive as high wages as he would receive in San Francisco. 
Interest rates are higher in Montana and Texas than in 
Massachusetts. Between different countries the differences 
in wages and in interest rates are much more striking. An 
American laborer receives wages one hundred per cent. 
higher than the wages paid similar laborers in most parts 
of Europe. The wages of labor in China and India are 
still lower than those of Europe. Interest rates in England 
and Holland are on the average considerably lower than 
interest rates in the United States ; in parts of Latin Amer- 
ica interest rates are considerably higher than in the United 
States. The explanation of these facts is of course to be 
found in the differences in the productivity of labor and 
capital in the different localities and countries. We are 
here concerned with the effects of such differences upon the 
profits of the enterpriser. 

Let us suppose that an employer of large numbers of 
unskilled laborers in the United States sends agents to 
Europe, or even to the Orient, to obtain a supply of labor. 
What the agent will offer for, say, two years' labor will be 
the local rate of wages for that period of time together with 
such a premium as may be necessary to overcome the re- 
luctance of laborers to leave their native land. The cost 
of labor is thus determined chiefly by the standards of pro- 
ductivity prevailing in countries from which the laborers 
are imported, while the value of the labor to the enterpriser 
is determined by American conditions of productivity which 
are admittedly more favorable. By virtue of the labor con- 
tract the employer is thus enabled to retain for himself a 
part of the product of the labor. 

It is obvious that the possibility of obtaining a profit of 
this nature depends upon the character of the laws relating 



202 INTRODUCTORY ECONOMICS 

to labor contracts. If the enterpriser cannot enforce the 
contract by law the laborers whom lie has imported may 
desert him before their services have yielded adequate com- 
pensation for the cost of bringing them to the country. In 
the United States to-day, not only would such a contract 
be unenforceable, but the importation of laborers from 
foreign countries under such contracts is a punishable 
offense. This was not formerly the case, and one of the 
important sources of profits in early American economic 
history was of the character that has been described. In 
many parts of the world, especially in the tropics, the same 
thing is true to-day. There are even companies which make 
it their sole business to supply enterprisers with contract 
laborers from China and India. Such companies derive 
their profit from the product of the laborers, part of which 
is made over to the company by the enterpriser who employs 
the laborers. 

We need not here consider the reasons that have led 
to the general condemnation of enterprise that relies for 
its profits on differences in local rates of wages. What we 
are more immediately concerned with is the natural limita- 
tion upon profits of this nature. Let us suppose that the 
Chinese coolie in his own home can obtain an annual wage 
of $50, while his services on a Spanish- American plantation 
or other enterprise are worth $250 per annum. Allowing 
$150 for bringing the laborer from China and for his return, 
and $50 a year to overcome his reluctance to leave his native 
land, there would remain, on a two-year labor contract, a 
profit of $150 to the enterpriser, if he imported the labor 
directly, or to be divided between the enterpriser and the 
coolie labor company, if the latter acts as intermediary. 

Under the assumed conditions the business of import- 
ing coolie laborers would quickly expand. As the number 
of Chinese laborers who are willing to leave their native 
country under such contracts is by no means unlimited, com- 
petition among labor importers would force up the wages 



INTRODUCTORY ECONOMICS 203 

offered to the coolies. Again, the increasing supply of 
coolie labor in the employing region would reduce marginal 
productivity — that is, the value of the services of a laborer — 
in those regions. And these tendencies would continue to 
operate until the profit of the business of importing laborers 
disappeared. 

We may apply the same reasoning to the case of profits 
arising from the transfer of capital from regions where its 
productivity is low to regions where its productivity is 
relatively high. A mortgage loan company may borrow 
capital in New York at five per cent, interest and loan it in 
Texas at seven per cent. The loan company thus receives 
a profit of two per cent. How is this profit produced? 
Clearly it is a part of the product of the capital set at work 
in Texas. A Texas enterpriser might have borrowed the 
capital directly, keeping for himself the profit that would 
otherwise have gone to the loan company. 

This source of profit, also, is one that must eventually 
run dry. The draining away of capital from New York 
would tend to raise the interest rate there — though hardly 
perceptibly, owing to the vast supply of capital in the na- 
tion's financial center. The influx of capital into Texas 
would reduce the productivity of capital in that State, until 
at last nothing would be gained by further transfer of 
capital. 

In any important industrial center the productivity of 
labor and of capital may at a given time vary from industry 
to industry, while the wages of labor and interest on loan- 
able capital vary little, if at all. We may in thought ar- 
range the different industries of such a center in a series, 
according to degree of productivity of labor and capital in 
each one. Labor and capital will receive no higher rewards 
in any industry than in the one that stands lowest in the 
series. If we assume that in this least productive industry 
labor and capital receive all that they produce — and we 
can hardly assume that they receive more than this — we 



204 ' INTRODUCTORY ECONOMICS 

see clearly that they must receive less than they produce in 
all the industries higher in the series. In the more pro- 
ductive industries the products of labor and capital afford 
a surplus above wages and interest, which takes the form of 
a profit to the enterpriser. 

Let us suppose that the American public, awakening to 
the significance of the ghastly record of railway accidents, 
insists that steel passenger coaches replace the wooden cars 
now in use, and withholds its patronage from railway com- 
panies that refuse to change their equipment. The demand 
for steel cars would become enormous ; years would have to 
elapse before the existing establishments could satisfy it. 
The car building companies, for a time, could sell their 
output at very high prices. The productivity of labor and 
capital in such establishments, measured in terms of price, 
would be abnormally high. But the wages of laborers en- 
gaged in building steel cars would be no higher than the 
wages of equally skilled laborers in any other branch of the 
iron and steel industries. There would accordingly be a 
surplus above costs, or a profit to the enterpriser. The car 
building companies would pay no higher rate of interest 
on borrowed capital than any other manufacturing com- 
panies in the vicinity. A surplus originating in the ab- 
normally high productivity of capital would thus be added 
to the profit from labor. 

In the course of time the existing establishments would 
increase their capacity and new companies would enter the 
field. The price of steel cars would fall — that is, the pro- 
ductivity of labor and capital in the industry, measured in 
terms of value, would decline. The increased demand for 
labor might slightly raise wages in all the iron and 
steel industries. Thus the profits of the enterpriser would 
gradually be reduced, until at last they disappeared alto- 
gether. 

In any industry the productivity of labor and capital 
may vary from establishment to establishment, although 



INTRODUCTORY ECONOMICS 20^ 

there may be no variation in the rates of wages paia. We 
may, if we Hke, arrange the establishments in a series, ac- 
cording to the degree of productivity of labor and capital, 
just as we did in the case of industries of varying produc- 
tivity. No higher wages or interest will be paid by any 
establishment than by the establishment working at the 
greatest disadvantage. As this establishment will pay to 
labor and capital no more than these agents produce, 
it follows that the better establishments will not need 
to pay out in wages and interest the whole product of 
labor and capital. A profit is left over for the enter- 
priser. 

Differences in the productivity of labor and capital in 
the same industry may be due to differences in methods of 
production, to differences in the business capacity of enter- 
prisers, or to differences in the location of plant. If the 
superiority of one establishment over others arises from bet- 
ter methods of production, it cannot continue for any great 
length of time — unless indeed the establishment enjoys a 
monopoly of its method, secured by a patent. In the end 
the better method of production is adopted generally ; prices 
fall or wages rise until there remains no profit for the 
enterpriser. 

One business man may, however, show greater enter- 
prise than others in adopting new methods as soon as they 
appear. By the time that any particular invention has be- 
come the common property of the industry, the more enter- 
prising business men have introduced some new method, 
from which they are able to derive profits for a time, until 
this method, too, becomes the common property of the in- 
dustry. Thus an able enterpriser may secure a permanent 
flow of profits from a series of improvements of method, 
although the profits from each successive improvement are 
quickly annihilated by competition. 

One business man may have greater skill than another 
in selecting workmen and in maintaining harmonious rela- 



206 INTRODUCTORY ECONOMICS 

tions with them; in deciding just what grade of the com- 
modity which he produces will best suit the needs of the 
purchasing public ; in determining the proper proportions in 
which to combine materials in the production of commodi- 
ties of ephemeral demand. Advantages that are secured in 
this way have a certain degree of permanence. Other enter- 
prisers may adopt methods that are to all appearances the 
same ; yet they may fail of attaining the same results. What 
they lack is the business instinct with which the more com- 
petent enterpriser is endowed. The latter may therefore 
enjoy a permanent income from this source. Such an in- 
come is usually classed with profits; but if we examine it 
carefully we shall see that it is more properly a special kind 
of wages. It exists only by virtue of the continued exercise 
of the faculties, mental and physical, of the enterpriser. 
For the exercise of such faculties a man might demand, and 
would receive, a salary if he chose to enter the employ of 
another instead of continuing in business on his own 
account. 

The income arising from superiority of location may be 
transient or permanent. It may be that by virtue of prox- 
imity to the sources of raw material or of fuel, or by virtue 
of a cheaper labor supply, a certain grade of cotton cloth 
can be manufactured more cheaply in the Carolinas than in 
New England. So long, however, as the Carolinas are un- 
able to supply the demand for that grade of cloth, the price 
will remain high enough to cover cost of production in 
New England — that is, high enough to give Carolina pro- 
ducers a profit. If this is the case, enterprisers who con- 
template the erection of new mills will naturally choose the 
Carolinas as their location. Whenever New England mills 
wear out, their owners, instead of rebuilding in the same 
spot, will transfer their business to the South. Under the 
conditions the entire industry will eventually migrate to the 
more favorable location. The price of labor in the Carolinas 
will gradually rise and the price of the cloth will gradually 



INTRODUCTORY ECONOMICS 207 

fall until no producer longer receives a profit on account of 
location. 

But let us suppose that in the favored location there is 
room for only a limited number of establishments. Let us 
say that on the banks of a certain river, which serves as a 
cheap means of transportation of raw materials and of fin- 
ished products, there are suitable locations for only a dozen 
establishments, while a hundred establishments are required 
to supply the demand for the commodity which these es- 
tablishments produce. The price of the commodity will then 
remain permanently at a figure that covers cost of produc- 
tion in the establishments that do not enjoy the advantages 
of the favored location. The establishments that do enjoy 
these advantages will therefore yield a permanent income 
that resembles profit. 

If, however, we analyze this income carefully we shall 
see that it is not a true profit. If the land on which the 
establishments stand is held by the enterpriser under lease, 
he will, at each renewal of the lease, make over to the owner 
of the land, as rent, a payment corresponding with the so- 
called profit arising from superiority of location. And this 
reveals the nature of the apparent profit. It is ground rent, 
irrespective of the facts of ownership. 

All the forms of profit that have been described — so far 
as they are true profits — are alike in that they are transitory 
in their nature. The very existence of such profits gives 
rise to competition, and competition eventually annihilates 
them. It is evident that if, in any case, competition can be 
prevented from appearing, profits may be transformed into 
a permanent income. 

We have seen that one of the possible sources of profit 
is the introduction of a new and more fruitful method of 
production. So long as the method is confined to one out 
of a number of competing establishments, prices remain at 
a level which covers cost of production in the establish- 
ments which do not employ the new method. If the new 



208 INTRODUCTORY ECONOMICS 

method of production is really an innovation in industry, 
and if it is of such a nature as to admit of definite de- 
scription — as, for example, a mechanical device for saving 
labor — the enterpriser who invented it may take out a 
patent, which will assure to him the exclusive right of using 
it for a period of time — seventeen years, in the United 
States. During this period he may continue to enjoy the 
profits arising from the use of the method. He may, of 
course, sell the right of use to other enterprisers, in which 
case he makes labor and capital more productive in the es- 
tablishments buying the right, reserving for himself, in the 
shape of payments for the use of the patent, a part of the 
product of these agents of production. 

Somewhat analogous to the profits arising from a 
patent are the profits arising from the use of a trade-mark 
or from the "good will" of a concern. A certain brand of 
soap, bearing the name of the man who first placed it on 
the market, has, let us say, a reputation for purity estab- 
lished by long years of honest business. Another soap bear- 
ing another name may be just as pure; but the consumer 
has no adequate means of determining qualities, and so pre- 
fers the brand which he has always believed to be good. It 
is evident that the manufacturers enjoying such a firm hold 
on the popular favor can charge somewhat higher prices 
for goods of a given grade than can manufacturers who 
have their reputation yet to establish. So a merchant who 
has established a reputation for upright dealing, or who has 
succeeded in attracting to himself the patronage of the 
wealthier classes of a city, can charge somewhat more than 
can his less fortunate competitors. The public esteem which 
an enterpriser enjoys — the good will of the business — is 
sometimes only an insignificant source of profits. Some- 
times, however, it is an exceedingly important source. In 
many cases the good will of a manufacturing or mercantile 
establishment is worth more than its aggregate tangible 
assets. 



INTRODUCTORY ECONOMICS 209 

One further source of permanent profits deserves con- 
sideration here — ^monopoly. In the strictest sense of the 
term the profits from a trade-mark or a patent are monopoly 
profits. Such profits, however, are Hmited to one out of a 
number of competing enterprisers in an industry. The 
monopoly profit which we are now considering may be en- 
joyed by all the enterprisers in an industry. 

Let us suppose that all the manufacturers of tin plate 
agree to reduce output twenty per cent, in order to force up 
prices. If the various producers can be held to their agree- 
ments and if new producers can be kept from entering the 
field, there is no reason why every enterpriser in the busi- 
ness should not enjoy a permanent profit. In the chapter 
on monopoly price we saw how this can be done. What the 
monopolists do, from the point of view of distribution, is 
this: A group of allied enterprisers throw a fence, as it 
were, around a particular field of industry. They limit the 
amount of labor and capital admitted to the field, so that 
the productivity of these agents remains higher than in the 
unmonopolized fields. The wages and interest paid by the 
monopoly are no higher than wages and interest in the un- 
monopolized fields. Consequently there remains in the hands 
of the monopolistic enterprisers a surplus, or profit. 

We saw in the last chapter how it is possible to arrive 
at the value of a capital good, such as a field, by capitalizing 
the income at the current rate of interest. Permanent profits 
may be reduced to a capital value in the same way. If the 
profit from a monopoly is $100,000 a year, and if there is 
good reason for believing that it will continue to be the same 
from year to year, the monopoly itself is worth as much as 
a sum of capital that will yield $100,000 interest per an- 
num. If capital generally yields five per cent., the monopoly 
is worth $2,000,000. If the enterprisers having such a 
monopoly were to sell out their interests, they would de- 
mand that sum over and above full payment for all the 
buildings, machinery, and other tangible assets of their busi- 



210 INTRODUCTORY ECONOMICS 

ness. The same thing is true of the profits arising from 
the good will of a business. These profits will be capi- 
talized, and the buyer of the business will have to add the 
capital value of the profits to the value of the tangible capi- 
tal goods. 

The value of a patent is found in a similar manner. 
The only difference is that the profits from this source cease 
upon the expiry of the patent. What the buyer pays for is 
the right to a certain estimated income for a definite num- 
ber of years. If the annual income is estimated at $5,000 
a year, and the patent has ten years to run, the simplest way 
of arriving at the value of the patent is to find the present 
value of each year's income, and add these sums together. 
If the current rate of interest is four per cent., the present 
value of $5,000 due in one year is obviously equal to a 
sum which, plus interest for a year, will amount to $5,000. 
That sum is about $4,810. $5,000 to fall due two years 
hence is worth a present sum which together with compound 
interest at four per cent, will in two years amount to $5,000 — 
$4,625. By a similar process — known as discounting — ^the 
value of each year's income may be ascertained, and by addi- 
tion, the present value of the patent is established. 

All profits, whether monopolistic or not, are from the 
point of view of distribution a part of the product of labor 
and capital which various circumstances enable the enter- 
priser to retain for himself. It may therefore appear, at 
first thought, that the existence of profits is evidence of in- 
justice in the distribution of wealth. 

Upon reflection, however, we see that this is not true. 
Profit in many cases plays an important part in stimulating 
economic progress; in many other cases the existence of 
profit serves as a means of distributing the agents of pro- 
duction in such a way as best subserves the interests of so- 
ciety. An income that must exist if society is to be progres- 
sive and if the best disposition is to be made of its produc- 
tive resources can hardly be regarded as unjustifiable. 



INTRODUCTORY ECONOMICS 211 

It is the hope of profits that induces the enterpriser to 
devise improved methods of production, or to adopt im- 
provements devised by others. In doing this the enterpriser 
increases the productivity of labor and capital, reserving 
for himself, as long as he can, the benefits of this increased 
productivity. But sooner or later the new method finds 
general application in the industry, and the enterprisers are 
forced to turn over the benefits arising from it to labor and 
capital, in the form of increased wages and interest, or to 
the consumer of commodities in the form of lower prices. 
In the latter case all laborers and capitalists gain by an in- 
crease in the purchasing power of their incomes. 

When profits arise from a general increase in the de- 
mand for a commodity, the title of the enterpriser to the 
income is perhaps not quite so clear. But such an increase 
in demand shows that the amount of labor and capital de- 
voted to the industry affected by the increased demand 
should be increased. This result can be brought about only 
through the action of enterprisers. Now, if enterprisers re- 
ceived no profit from enlarging old works and establishing 
new ones, why should they trouble themselves with doing 
this? If on the other hand they may for a time keep for 
themselves as a profit a part of the price of their products 
they will naturally endeavor to enlarge their works as 
quickly as possible. When at last as much labor and capital is 
devoted to the industry as is socially expedient, profits cease 
through rise in wages and interest or through fall in prices. 

Of the forms of profit that are classed as monopolistic, 
those arising from patented inventions and from good will 
need no defense. The former is the reward for one of the 
most important services to society. The inventor can never 
get for his services, at any time, more than they are worth 
to society ; at the expiry of the patent the invention becomes 
the common possession of all. The profits arising from good 
will are a reward for honorable business dealings, and can 
be retained only so long as the enterpriser is worthy of them, 



212 INTRODUCTORY ECONOMICS 

The profits of an ordinary monopoly stand on an en- 
tirely different footing. The productivity of labor and capi- 
tal in the field controlled by the monopoly is rendered ab- 
normally high not through superior organization and com- 
bination of these factors in production, but through the 
maintenance of an artificial scarcity of them, which is di- 
rectly opposed to the interests of society. While the action 
of any one out of a number of competing enterprisers, each 
striving to increase his own profit, necessarily operates to 
increase the aggregate wealth produced by society, the ac- 
tion of a combination of enterprisers striving to secure a 
monopoly profit as necessarily operates to reduce the aggre- 
gate wealth production of society. Through his anti-social 
conduct the monopolistic enterpriser receives a permanent 
profit, the fruits of other men's labor and capital. The enter- 
priser who carries on business under conditions of competi- 
tion receives, as a reward for his important services to so- 
ciety, only a temporary profit. 

It appears, therefore, that the elimination of monopoly 
profit through legislative action, if possible, is eminently de- 
sirable. It is, however, to be borne in mind that this cannot 
always be done without injustice. We have seen that 
monopoly profit, being permanent, may be capitalized. If 
a combination of manufacturing enterprises makes possible 
a monopoly profit of $100,000, the selling value of the com- 
bined enterprise — or of the capital stock representing it — is 
increased by the capital value of an income of $100,000. 
Now, the original promoters of the monopoly do not con- 
tinue to own it forever. Some of the stock in it may pass 
to their heirs ; some of it may be sold to persons who do not 
know that a great part of its value is merely the capitaliza- 
tion of a wrongful monopoly profit. If then the profit of 
the monopoly is eliminated, the latter class of persons find 
themselves deprived of an income the right to which they 
purchased in good faith as an income from capital. 



CHAPTER XV 
Money 

In the foregoing chapters frequent use has been made 
of the concept price, which of course implies the concept 
money, since price is nothing but exchange value, expressed 
in terms of money. It has been tacitly assumed that money 
is in general use and that its value remains constant, price 
fluctuations being due to changes in the conditions of produc- 
tion or consumption of other things. The latter assumption, 
as every one familiar with recent discussions of economic 
policy is aware, cannot pass unchallenged. The value of 
money, like the value of all other things, is subject to con- 
tinual fluctuations, and these fluctuations give rise to some 
of the most important problems of practical economics. 

What is money? How did it originate, and what func- 
tions does it perform? What is meant by the value of 
money, and how is this value determined? When the value 
of money changes, what are the effects of such changes upon 
the welfare of society at large and that of the several classes 
making up society? What should be the policy of govern- 
ment in respect to the monetary system of a country ? These 
are some of the questions that political economy has for a cen- 
tury or more been endeavoring to answer. Such is the com- 
plexity of the problems involved, however, that the conclu- 
sions even of professional economists are widely divergent, 
to say nothing of the differences of opinion among men of 
affairs. 

We may profitably begin our study by considering what 
it is that the plain man regards as money. Anything that 
is accepted by practically every one in exchange for his goods 
or services, with the intention of using it only for the pur- 
pose of exchanging it ultimately for other goods or services, 



2T4 INTRODUCTORY ECONOMICS 

is popularly regarded as money. This view, which is also 
that of many of the ablest writers on money, we may safely 
adopt as our own. Under different conditions of economic 
development, different concrete things have served as money 
— shells, beads and other ornaments, bits of metal coined 
or uncoined, and even consumable commodities, like cattle, 
furs, spirits. With the evolution of trade, a corresponding 
evolution of money has taken place, those forms of money 
which were fitted for use when trade was merely an inci- 
dental part of economic life giving way to forms of money 
adapted to a complex system of commerce. 

The origin of money antedates all historical records. 
Nevertheless, we know enough about the life of primitive 
man to construct a plausible view of the circumstances under 
which money must have come into existence. In the earlier 
stages of human evolution exchange, at least in the modern 
sense of the term, was unknown; hence of course money 
could not have existed. When it first became customary to 
make exchanges, goods were doubtless bartered directly for 
goods, as is sometimes the case even to-day. Certain arti- 
cles, however, were more frequently the objects of exchange 
than others, as, for example, strings of sea shells, articles of 
copper, silver and gold suitable for personal adornment. 
Such articles, unlike the common necessaries of existence, 
could not be produced by any one desiring them. Not being 
essential to life, they would naturally be sacrificed by their 
possessors in time of need. We can easily see, therefore, 
why articles of this nature should have been among the earli- 
est to be freely purchased and sold. How a medium of ex- 
change evolved from them we can best understand if we try 
to picture to ourselves the conditions under which the evolu- 
tion took place. 

Let us imagine that in a primitive community, where 
trade, in the form of barter, has become customary, one man 
finds himself possessed of a larger herd of cattle than he 
needs. He may be in great need of an additional slave. Yet 



INTRODUCTORY ECONOMICS 21$ 

he may be quite unable to find a person who has a super- 
fluous slave and who would desire more cattle. Direct ex- 
change, therefore, is out of the question. 

But the owner of cattle may not decide to keep a su- 
perfluity of them merely because he cannot get for them 
exactly the thing that he most needs. He may cast about 
for some other article against which to exchange the cattle. 
In common with all primitive men — and some men who are 
not to be classed as primitive — he has an insatiable desire 
for ornaments which may arouse the admiration or envy 
of his fellows. Quite naturally, then, if opportunity offers, 
he exchanges his superfluous cattle for a silver bracelet. 
Shortly afterward he may meet with some one quite willing 
to exchange a slave for the bracelet. The final result of the 
two transactions, from the point of view of the owner of the 
cattle, is simply the exchange of the cattle for the slave. The 
bracelet has served as a medium through which the exchange 
has been effected. And this is true, although none of the 
parties to the two transactions is conscious of the fact. 

Now let us suppose that the owner of the cattle, at the 
time of exchanging his cattle for a bracelet, has no particular 
desire for any other form of wealth. At the end of a year, 
however, he may come to need a slave, and use the bracelet 
to procure one. In this case, too, the bracelet serves as a 
medium in the exchange of the cattle for the slave. It further 
serves to enable the owner of the cattle to retain their value 
in his hands until he may desire to transform it into some 
other useful commodity. Thus the bracelet serves as a store, 
or repository of value. 

It is highly probable that the same bracelet will on fre- 
quent occasions perform the same function of medium of 
exchange and store of value. If there are many similar 
bracelets in the community, it is quite possible that men will 
get into the habit of selling their goods for bracelets, with 
the expectation of using the bracelets merely to buy other 
goods with. In such case the bracelet ceases to be an ordi- 



2l6 INTRODUCTORY ECONOMICS 

nary object of use, and becomes money. It will then assume 
a further function. Whenever men think of buying or sell- 
ing commodities, they will estimate the worth of such com- 
modities in terms of bracelets. The latter, then, become a 
measure or a standard of value. 

Just at what point bracelets cease to be ordinary com- 
modities and become money it would of course be impossible 
to say. Some men may accept them solely with a view to a 
further exchange. Some may accept them primarily with 
a view to further exchange, yet with the alternative of per- 
sonal use before them ; still others may accept them with no 
intention of exchanging them for something else. To the 
first class of persons, the bracelets are money ; to the second, 
neither money nor ordinary commodities but something half 
way between; to the last class they are merely ordinary 
commodities. If the last two classes are relatively insig- 
nificant, the bracelets are properly money. We do not hesi- 
tate to call nickels and dimes money, although certain of 
the aboriginal inhabitants of the United States perforate 
all they can obtain and hang them in strings from their ears. 

Such articles as bracelets, being primarily designed for 
personal use, would be an awkward medium of exchange. 
Ornaments, in order to satisfy the desire for distinction, 
must differ in form, size, quality. Such differences in arti- 
cles serving as a medium of exchange, would be a serious 
handicap to trade. At each purchase or sale it would be 
necessary to discuss not only the qualities of the article 
sought or offered, but also the qualities of the article used as 
money. Hence as trade becomes more common, the articles 
serving as medium of exchange must become more and more 
uniform in appearance and quality. In some cases orna- 
ments assume a conventional form, like the sword coin of 
parts of the Orient. In other cases, representing a later 
stage in the development of money, the original purpose for 
which such articles were made is lost sight of ; the silver or 
copper is hammered into forms of more or less regular shape 



INTRODUCTORY ECONOMICS 21^ 

and uniform quality. In parts of the Philippine Islands, as 
late as the time of the American occupation, copper disks 
made by some of the native tribes circulated as money. 

A further stage in the development of money is the 
assumption by government of the exclusive right of making 
the bars or disks — coins — to be used as money. The disks 
of metal of private manufacture naturally differed consider- 
ably in quality as well as in weight. Such differences, 
negligible while trade was only slightly developed, became 
a serious matter when men began to rely upon exchange for 
many of the commodities of daily use. It seems probable 
that the purpose of governments in taking over the func- 
tion of coining money was to bring about the uniformity 
that an expanding trade demands. Whether this was the 
original purpose or not, the fact remains, however, that the 
most important function of government, in respect to mone- 
tary matters, is the establishment of uniformity of coinage. 
In the more advanced nations the coinage is now practically 
uniform. One gold eagle is in all essential respects as good 
as another. 

For an advanced commercial nation, uniformity in the 
value of money is, we can readily see, quite indispensable. 
No less indispensable is variety in the forms of money. In 
the rural districts of China, where trade is chiefly local and 
the articles of trade of low value, one kind of coins, and 
these of very low value, meets practically all needs. In a 
country like our own, with the greatest variety of business 
transactions to be performed through the medium of money, 
a wide variety of forms of money is required. For the 
smallest transactions it is necessary to have coins of a value 
which is low, relatively to bulk, as bronze cents, nickel 
five-cent pieces. For slightly larger transactions, coins 
of silver, which represent a greater value per unit of bulk, 
are more convenient. For transactions involving still 
greater values, gold coins are better adapted than silver; 
for the largest cash payments, paper money, which may be 



2t8 introductory ECONOMlt:S 

of any denomination, is the most convenient of all. How 
important is this variety in forms of money will be under- 
stood by any one who happens to be engaged in business 
in a town where at times the supply of small coins is not 
sufficient to meet the needs of petty trade, or in a section 
where silver coins are employed to the exclusion of paper 
in all transactions involving $io or less. 

We may now consider what is meant by the value of 
money, and how this value differs from that of other com- 
modities. Here also we may gain clearness of view by 
keeping in mind the probable evolution of money. If the 
bracelet of our earlier example is accepted by a man in 
exchange for his products with a view to his personal use, 
he will naturally value it solely with reference to the satis- 
faction which he expects to derive from it. If it is accepted 
with a view to its possible exchange for some other com- 
modity, he will value it partly with reference to the satis- 
factions to be derived from its use, partly with reference to 
its power to command other commodities. If the bracelet is 
accepted solely with a view to further exchange, its value to 
the man is nothing but its purchasing power. There must 
indeed be a stage in the evolution when bracelets are valued 
by some men with reference to their use as ornaments, by 
others with reference to their purchasing power. When, 
however, practically every one regards bracelets merely as 
the means for purchasing other things, the value of brace- 
lets to the community at large is their power to command 
other things in exchange. Each man will ascribe a high 
or a low value to bracelets according as their purchasing 
power is high or low. 

Under present conditions all men accept money in 
exchange for their possessions solely with reference to its 
employment in the purchase of other things. We may, 
therefore, define the value of money as its power to com- 
mand other things in exchange, or briefly, its purchasing 
power. Other commodities are valued by some men for 



INTRODUCTORY ECONOMICS 210 

what they will bring in exchange, by other men for the satis- 
faction to be derived from them directly or indirectly. The 
true cause of the value which men who hold ordinary com- 
modities for sale ascribe to such commodities is the value 
ascribed to them by those who will use them in the satis- 
faction of wants. There are practically no men who ascribe 
value to money as a means of direct satisfaction. In this 
respect, accordingly, the value of money is a unique phe- 
nomenon, requiring special explanation. 

The value of money, then, is its purchasing power. 
How is this power to be measured? Evidently not by 
reference to any particular commodity. A dollar may buy 
one and one-quarter bushels of wheat to-day and only one 
and one-fifth bushels to-morrow. We should not say that 
the value of money has declined, but that the price of wheat 
has risen. For there may be many other commodities in 
respect to which the purchasing power of money has in- 
creased. To form a true estimate of the value of money 
we must consider its power to command commodities in 
general. In order to measure changes in the value of 
money, we may form a list of the principal commodities, 
showing how much of each a dollar will command at differ- 
ent dates. By the method of averages we can then ascer- 
tain pretty exactly whether the general purchasing power of 
money has changed. This method has long been employed 
by economists, and it has been shown that through long 
periods of time the value of money fluctuates widely. A 
dollar will not buy so much to-day as it would have bought 
ten years ago. Very likely a dollar will buy more ten years 
hence than it buys to-day. 

The factors which determine the value of money, and 
hence the general level of prices, are so numerous and com- 
plex that only a provisional account of them can be given in 
this work. It is quite generally agreed that, other things 
equal, the greater the volume of money there is in the world, 
the lower will be the value of any unit of it. It is of course 



^20 INTRODUCTORY ECONOMICS 

true that there are in operation many influences affecting 
prices besides changes in the volume of money. Hence we 
cannot say that if the volume of money, twenty years hence, 
shall be twice as great as it is to-day, prices will be higher 
than they are to-day. This fact does not make it the less 
important for us to gain a clear view of the effect of a change 
in the volume of money. 

Let us suppose that through the discovery of a new 
gold field the world's supply of that metal is perceptibly in- 
creased. $100,000,000 worth of gold, let us say, is taken 
from the new mines every year. Some of the new 
gold may be used in the arts; but the greater part of 
it will find its way to the mints of the nations, and 
issue thence as coin. 

The only use which money subserves is that of purchas- 
ing other commodities. The fortunate owners of the new 
mines will therefore quickly enter the market as purchasers, 
either of consumable commodities or of capital goods or 
rights to capital goods — stocks, bonds, etc. There is no 
reason why the production of goods, whether consumable 
goods or instruments of production, should at once increase 
upon the discovery of gold. We may think of the supply 
of such goods as substantially unchanged. Now, new pur- 
chasers, with $100,000,000 to spend, appear upon the mar- 
ket. It is quite evident that competition for commodities 
will increase and prices will rise. 

Let us assume, for the m.oment, that the rise in price of 
the commodities purchased by the first owners of the new 
gold has no effect in stimulating the production of such com- 
modities. The enterprisers engaged in the production of 
these commodities, then, will enjoy abnormally large money 
incomes as a result of the high prices at which they sell their 
products. They will have more money to spend on other 
classes of commodities for their own use. As the production 
of these, we assume, has not yet been affected, they also 
must rise in price. And so the new gold will percolate 



INTRODUCTORY ECONOMICS 221 

from one economic stratum to another, everywhere raising 
prices. 

Our assumption that the production of the commodities 
demanded by the original owners of the new gold remains 
unchanged is purely arbitrary. The rise in prices would prob- 
ably lead enterprisers to enlarge their mills, or to run them 
overtime, and this would require more laborers and more cap- 
ital. The total supply of labor and capital at the command of 
society has not, however, been affected by the increase in the 
volume of money. The only way, then, in which an enter- 
priser can secure additional labor and capital is by enticing 
these agents away from the employment of other enterprisers. 
And this, it is evident, must raise the rates of wages and 
interest in the district where the expansion of enterprise oc- 
curs. 

After the rise in wages and interest, each laborer has 
more money to spend; he will therefore increase his pur- 
chases of the commodities suitable for his use. The supply 
of these, however, has not yet increased ; their price is forced 
to a higher level. Similarly the increased money income of 
the capitalists raises the prices of commodities taken by the 
members of that class. Eventually not only the price of all 
finished products, but the price of all raw material and other 
capital goods, and of all labor, will be affected. 

The new gold may be first used to purchase consumable 
goods, or it may be used to purchase stocks or bonds. In 
the latter case, the first effect is an increase in the price of 
these securities. But the sellers of the securities will use 
the money to buy other things. Eventually the effect must 
be felt in the market for commodities and labor. 

Instead of assuming that the supply of money is in- 
creased through new gold discoveries, we may assume that 
such increase in the money supply is brought about through 
an issue of paper money by the government. Suppose that 
the United States Government, in order to finance projected 
irrigation works, issues $100,000,000 in paper money. This 



222 INTRODUCTORY ECONOMICS 

money will find its way into circulation through the purchase, 
by the Government, of additional supplies and the payment 
of wages to new employees. The supply of steel, cement, 
and other commodities needed by the Government, however, 
is not increased at once by the issue of new money ; hence the 
price of these supplies must rise when the Government enters 
the market as an unanticipated purchaser. Similarly, wages 
are forced up by the new demand for labor created in this 
way. Through attempted expansion of business and through 
increased liberality of expenditure, the enterprisers and la- 
borers first affected by the increase in the money supply 
transmit its effects, in the form of increased prices, to men 
engaged in other industries. In the end general prices and 
general costs are on a higher level than they would other- 
wise have been. 

Not all exchanges are effected through the medium of 
money. Barter exists even to-day, although this form of ex- 
change may be ignored, as of very slight importance. Many 
exchanges — indeed, much the greater number, in a society 
like our own — are effected through the medium of various 
substitutes for money. Let us suppose that A, a person of 
unquestioned financial standing, buys of B commodities 
worth $100, and instead of paying cash, gives a promissory 
note, due in six months. B in turn may buy $ioo worth of 
goods from C, paying for them not with cash, but with A's 
note, properly endorsed. C may use the same note to effect 
a purchase. At any given time a vast number of such notes 
may be at work effecting exchanges, although each one may 
be transferred only two or three times before its maturity. 
The effect of the use of such notes as a means of exchange 
is the same as that of an increase in the supply of money. 
A man who can use a note in this way is enabled to enter 
the market for the purchase of goods as he could not have 
done if sellers all insisted upon cash payment. The effec- 
tive demand for commodities, therefore, is increased, just as 
it would be by an increase in money. We need not at this 



INTRODUCTORY ECONOMICS 223 

point carry further the analysis of the effects of the intro- 
duction of such substitutes for money, as these effects will 
receive full discussion in the next chapter. 

The value of money, as we have seen, is affected by 
changes in the volume of money and in the use of substitutes 
for money. It is also affected by changes in the volume of 
business to be transacted through the use of money. Where 
most men produce for themselves the principal commodities 
which they need, exchanging only their superfluities for 
luxuries, a very little money will meet the requirements of 
trade. Where on the other hand men produce almost ex- 
clusively for sale, a large volume of money or of substitutes 
for money is required. If we imagine that men suddenly 
change from the system of production for immediate con- 
sumption to the system of production for the market, with- 
out any change in the volume of money and of its substitutes, 
we can easily see that the price level must be lowered. 
Where one commodity under the earlier system was offered 
for sale to the possessors of money, one hundred may be 
offered under the later system. Some sellers of commodities 
would then find that at the scale of values originally existing 
they would be unable to find purchasers with money to pay. 
They would accordingly reduce prices, and so attract to 
themselves a part of the money supply. This would leave 
other sellers without buyers, and these in turn would lower 
prices. Thus the price level would fall or, what amounts to 
the same thing, the value of money would rise, until all sell- 
ers could find buyers at the prevailing prices. 

The assumption that the system of production could 
change thus rapidly without a change in the volume of the 
media of exchange involves unrealities, as we know that 
exchange and the medium of exchange must evolve together. 
Yet it points to a real fact : that exchange may expand more 
rapidly than the volume of the media of exchange, necessi- 
tating a lower price level. 

It must now be evident that changes in the volume of 



224 INTRODUCTORY ECONOMICS 

money are not alone sufficient to explain changes in the value 
of money, or price changes. The development of substitutes 
for money and changes in the volume and character of busi- 
ness transactions must also be taken into account. There- 
fore, although we may say that an increase in the volume of 
money will, other things equal, raise general prices, we can- 
not say in what degree any specific addition to the money 
supply will raise prices. A doubling of the money supply of 
the world might conceivably double prices. In all probability, 
however, prices would be increased by less or by more than 
one hundred per cent. For the readjustments consequent 
upon such an extraordinary expansion in the volume of 
money would probably result in vital changes in the volume 
and character of business, the nature of which it would be 
impossible to predict. The student is cautioned against the 
view that an increase in the money supply, brought about in 
any way that is known to practical experience, can leave the 
industrial mechanism unchanged while changing the scale of 
prices. 

We may also say that, other things equal, all prices will 
be raised by any important increase in the volume of money. 
But we cannot say that all prices will rise in the same pro- 
portion. Indeed, this is something that a little reflection on 
business conditions shows to be impossible. The supply of 
some commodities is easily increased, while the supply of 
other commodities can be increased only after the lapse of a 
considerable time. If the new money is spent largely on 
commodities of the first class, the attendant rise in price is 
quickly counteracted, in some degree, by increase of produc- 
tion. If it is spent on commodities of the second class, there 
can for a time be no such counteracting influence. 

The fact that not all prices rise in the same degree, and 
the fact that some classes of business relations are not directly 
affected by price changes, render the question of increase 
or decrease in the volume of money of vital practical impor- 
tance, It lies in the power of g^overnrnent, within certain 



INTRODUCTORY ECONOMICS 225 

limits, to expand or contract the money supply, and there- 
fore to change the price level. In order to form an intelligent 
opinion of proposed plans for changing the volume of money 
through governmental action, we must consider what social 
classes are affected favorably or adversely by such changes. 

When general prices are rising, the wages of labor will 
also tend to rise. But it may take some time after prices have 
begun to rise before enterprisers decide to extend their busi- 
ness operations. The demand for labor, accordingly, does 
not for a time increase and wages remain unchanged. The 
laborer receives no higher wages per week or month; the 
commodities he buys with his wages have risen in price. It 
follows that the command of the laborer over the neces- 
saries and comforts of life is for the time diminished. Even- 
tually, to be sure, enterprisers will endeavor to enlarge their 
businesses, and wages will rise. But if the prices of commo- 
dities continue to rise, it may well be that for a long period of 
time the rise in money wages will not be an adequate offset 
for the increased expense of living. It is a well-known fact 
that during the Civil War the prices of commodities rose far 
more than the price of labor. 

For many services compensation is fixed by law or by 
custom. The salaries of public officials remain fixed through 
long periods of time notwithstanding changes in the price 
level. The postal employee receiving $2,000 a year is seri- 
ously injured if prices of commodities rise, since years may 
elapse before the Government grants him an increase of 
salary. Physicians' fees, in most cases, are regulated by 
custom and can seldom be increased on account of an advance 
in general prices. 

The business relations most seriously disturbed by price 
changes, however, are those of creditor and debtor. Let us 
suppose that a farmer has borrowed $10,000, agreeing to pay 
off the loan in ten years, together with annual interest at 
six per cent. After the contract has been made, general 
prices, we will assume, rise twenty per cent. The farmer 



226 INTRODUCTORY ECONOMICS 

does not have to pay more than $600 interest each year, al- 
though the purchasing power of that sum has declined twenty 
per cent. At the end of the ten years, he will not need to 
pay more than $10,000, although this sum, for the same rea- 
son, represents a lower value. The creditor has been injured 
through the change in the price level just as much as he 
would have been if the debt had been arbitrarily scaled down 
to $8,000, prices remaining unchanged. The farmer, on the 
other hand, has gained materially. He receives higher prices 
for what he has to sell, and so is enabled to pay the annual 
interest and the principal when due with much less sacrifice 
than would otherwise have been necessary. 

Enterprisers as a class are benefited through a rise in 
general prices. What they have to sell commands a higher 
price ; their costs of production increase, but not proportion- 
ately. Mention has already been made of the fact that wages 
may not rise so rapidly as prices. Furthermore, most enter- 
prisers have some charges to meet that remain unchanged 
from year to year. If they occupy buildings and land not 
owned by themselves, these are probably held under long 
time leases. Until it is necessary to renew such leases, the 
rental cannot be adjusted to the change in the price level. 
Most enterprisers are heavily in debt, and the rise in the level 
of prices has the effect of reducing the burden of such debts, 
as in the case of the farmer of our illustration. A period 
of rising prices, to the active business man, is, therefore, a 
period of prosperity, whether it is a period of prosperity to 
the people as a whole or not. 

We have only to reverse our argument to show that in a 
period of falling prices, or rising value of money, the wage 
earners as a class gain, because wages do not fall as rapidly 
as prices; those receiving salaries fixed by law or custom 
gain yet more, because a readjustment of such incomes to 
the new scale of prices is long delayed; creditors gain 
through increase in the purchasing power of the interest and 
principal due them. The enterprisers as a class find profits 



INTRODUCTORY ECONOMICS 227 

succeeded by losses, and complain bitterly of business depres- 
sion. 

The value of money can neither rise nor fall without in- 
flicting unmerited hardship upon some members of society. 
Any change in the value of money, therefore, is an evil. 
The evils of a rise in the value of money are, however, more 
easily perceived than the evils resulting from a fall in the 
value of money. When money rises in value — or, what 
amounts to the same thing, prices fall — enterprisers incur 
losses, and restrict their operations, reducing their working 
force as far as possible. Many debtors find themselves un- 
able to sustain their burdens, and become bankrupt. The 
hardships of unemployment and bankruptcy quickly attract 
public attention. The hardships arising from a fall in the 
value of money, or rising prices, are more widely diffused 
and less patent to the eye of the observer. Wage earners 
and the recipients of fixed incomes, whether from labor or 
from loaned capital, encounter greater and greater difficulty 
in making ends meet, but this fact receives little 'attention at 
a time when enterprisers great and small are enjoying pros- 
perity. Accordingly it is quite natural that when prices are 
falling men should endeavor to mend matters through the 
action of government, while the evil effects of a general rise 
in prices are usually left to mend themselves. 

It has already been indicated that money in its earliest 
form was not the creation of government, but the result of the 
natural evolution of trade. Governments early assumed the 
function of supervising the coinage of money, and this 
greatly facilitated the development of trade through the intro- 
duction of uniformity in quality and weight of coins. 

Although governments monopolize the manufacture of 
coined money, they do not thereby determine the value of the 
money. Coinage originally was simply an authoritative cer- 
tification of the weight and fineness of a bit of metal. The 
value of the coin depended upon laws of trade quite inde- 
pendent of the action of the government, 



228 INTRODUCTORY ECONOMICS 

In most modern nations the coinage of gold is nothing 
but this governmental certification of weight and fineness. 
Any owner of the metal may take it to the mints and have it 
coined, either freely, or upon payment of a small charge to 
cover the cost of coinage. The supply of gold coin, then, 
is in no way determined by government. It increases or 
declines with changes in the production of gold, and in the 
demand for it for use in the arts. This was formerly the 
case with silver coin also. Any owner of silver could take 
it to the mints and have it transformed into coin. In the 
popular phrase, the coinage of silver, as of gold, was free. 

If the government limited its action solely to the certi- 
fication of the weight and fineness of the metal coined, and 
admitted gold and silver alike to free coinage, business would 
be hampered by the existence of two independent forms of 
money, each fluctuating in value according to its own laws. 
There would be two scales of prices, one measured in gold 
and the other in silver. As a consequence numerous oppor- 
tunities for petty trickery would be presented to the unscru- 
pulous. 

But the government does not thus narrowly limit its ac- 
tion. Besides vouching for the weight and quality of metal 
in coins of silver and gold, it endows either all or a part of its 
coinage with legal tender quality. That is, certain kinds of 
money are declared by the government to be receivable in 
payment of all debts, public or private, when no particular 
kind of money has been specified in the contract creating the 
debt. This does not mean that debtor and creditor may not 
make private arrangements for the use of some other kind 
of money. If gold coin is the sole legal tender, a man may 
nevertheless borrow money, agreeing to repay the loan in 
silver. Such a contract would ordinarily be enforced by the 
courts. But if a man promises merely to pay $i,ooo, his cre- 
ditor can, if he wishes, demand payment in gold. Similarly, 
if a man agrees to pay a certain salary to an employee, he 
Qan be compelled to pay in gold. If on the other hand the 



INTRODUCTORY ECONOMICS 229 

creditor would prefer some other form of money to gold, he 
cannot compel his debtor to respect his preference in the 
matter. 

When gold and silver are freely coined and are equally 
endowed with the legal tender quality, it may happen that a 
dollar of the one metal is inferior in value to a dollar of the 
other. Suppose that the pure metal contained in a gold 
dollar is one-sixteenth in weight of the pure metal in a 
silver dollar — approximately the ratio formerly employed 
in the United States. The market value of uncoined gold, 
however, might be more than sixteen times as great, per unit 
of weight, as that of uncoined silver. If both gold and silver 
coins remained in circulation, it would be possible for a man 
to make a profit by purchasing uncoined silver, turning it 
into coin at the mints, and exchanging the silver coins thus 
obtained for gold coins. Silver would be brought from all 
the quarters of the world, coined, and exchanged for gold 
coins, and the gold coins would be exported in payment for 
it. Thus gold coin would tend to disappear from the cir- 
culation altogether. 

If on the other hand uncoined gold was worth less than 
sixteen times its weight in silver, the latter metal would 
be withdrawn from the circulation. In the history of the 
United States the tendency for the cheaper money, whether 
silver or gold, to displace the dearer money, was constantly 
manifesting itself, until the policy of the free coinage of sil- 
ver was abandoned in 1873. All other countries that have 
attempted to coin both metals freely have had a similar ex- 
perience. As a consequence all the more advanced commer- 
cial nations have ceased to coin silver freely. Only enough 
silver is now coined to meet the needs of petty trade, and 
provision is made, in a manner to be described later, to main- 
tain such coins at a parity with gold. 

Let us suppose that a country like the United States 
should abandon the present plan of coining only gold freely, 
^nd admit to free coinage both silver and gold, at the fixed 



230 INTRODUCTORY ECONOMICS 

ratio of sixteen to one, as was proposed in 1896 by one of the 
great political parties. What would be the effect upon the 
American coinage? The market value of silver has fallen 
so low that an ounce of silver is worth less than one-twenty- 
fifth of the value of an ounce of gold. Consequently it would 
be very profitable to buy up uncoined silver, both in America 
and in other countries, present it at the mints, and exchange 
the coined silver for gold, so long as any gold coins remained 
in circulation. It would obviously be only a very short time 
before gold disappeared entirely from the circulation. 

The great demand upon the silver supply that would 
thus be occasioned would no doubt increase the value of that 
metal. The gold displaced from the American coinage 
would be thrown upon the markets of other countries, and 
would reduce the value of gold there. Nevertheless, an 
ounce of gold would probably continue to command more 
than sixteen ounces of silver — ^perhaps twenty ounces. A 
dollar (silver) would then be worth less, in gold, than a dol- 
lar (gold) was worth before the opening of the mints to 
silver. It would be worth still less relatively to commodities. 
That is, general prices in the United States would have been 
forced to a higher level. 

If all the countries of the world had agreed to coin sil- 
ver and gold freely at the same ratio, it is quite probable that 
coins of both metals would have continued to circulate side 
by side. The chief reason why gold would leave the circula- 
tion of a single country, if placed at an unfavorable ratio with 
silver, is that in other countries it is given a higher coinage 
value. More gold would be used in the arts, perhaps, but 
much of it would remain in the coinage if all countries under- 
valued it equally, relatively to silver. 

The effect of such a universal adoption of bimetallism 
would be to increase the world's supply of money, and hence 
to raise prices. Now in the early nineties of the last cen- 
tury, it came to be generally known that prices were falling, 
and had been falling for a quarter of a century. The mov§- 



INTRODUCTORY ECONOMICS 23 1 

ment in favor of bimetallism, or the free coinage of both 
silver and gold at a fixed ratio, was an effort, probably mis- 
taken, to remedy the defects of an appreciating currency. 
Since that time the production of gold has greatly increased, 
and prices have been steadily rising. 

The money supply of a country may be increased 
through the issue of paper money by the government. Such 
money usually takes the form of notes, issued in behalf of 
the government and alleged to be payable at the treasury on 
demand. But a government is sovereign, and cannot be 
compelled to meet its promises unless it chooses to do so. 
Hence the person who receives such a note usually takes it 
with the intention of parting with it in the purchase of goods 
or in the payment of debts, not of presenting it at the trea- 
sury for specie. 

In order to give such notes currency, the government 
endows them with the legal tender quality. If the volume of 
paper money is narrowly limited, it may circulate at par. 
Most of us have taxes to pay, and paper money is accepted 
at par in payment of taxes. Many of us have debts to pay, 
and the law makes paper as good as gold for that purpose. 
If occasionally we receive paper money in exchange, we know 
that we can use it in one of these ways. So certain of this 
may we be, under the conditions, and so confident that others 
are in a like position, that we do not hesitate in accepting 
paper money at par in exchange for our goods and services. 

If, however, an enormous amount of paper money is 
issued by the government, so that we are all likely to receive 
more of it in exchange than we can certainly use at par, we 
begin to look upon it with suspicion. We exchange it, if 
we can, for "hard money" — gold or silver; if possible, we 
stipulate that we shall be paid in hard money for our commo- 
dities or services, offering our goods, if necessary, at lower 
prices than we would accept if paid in paper. Relatively to 
gold, paper depreciates. If there is enough of it issued, no 
one pays gold if he can avoid it, but uses paper instead. 



2^2 INTRODUCTORY ECONOMICS 

Thus the gold disappears from circulation, and paper be- 
comes the only money in use. Under the circumstances it 
is the worst possible kind of money : it fluctuates wildly in 
value, falling with rumors of additional issues, rising when it 
is rumored that the government intends to redeem it. At 
every change in its value some men gain unmerited profits 
and others suffer unmerited losses. 

If then a government exercises great moderation in the 
issue of paper money, depreciation may not occur. The in- 
crease in money will tend to raise prices, but not perceptibly ; 
and if prices are tending downward this effect may be bene- 
ficial. Why then do practically all students of monetary 
science agree that paper money is always an unmitigated evil ? 
Because governments almost never exercise moderation in 
the issue of paper money. They resort to paper money in 
time of need, usually while carrying on war. Thus they 
obtain funds without burdening the people with taxation. 
As the expenses of the war increase, more and more paper 
money is issued, until hard money is driven out of circula- 
tion, and the redundant paper currency falls lower and 
lower in value, as evidenced by constantly rising prices. 

In a well regulated monetary system, such as almost all 
the advanced nations now fortunately enjoy, all forms of 
money are maintained at a parity by the government. In the 
monetary system of the United States, for example, are to be 
found coins of gold, silver, nickel and bronze, as well as 
paper money. Part of the paper money consists of gold and 
silver certificates ; a small part of it of treasury notes, issued 
in payment for silver bullion ; part of it of "greenbacks" — 
promissory notes of the Government, a legacy of the Civil 
War. All these forms of money are maintained at an ab- 
solute parity by the Government. The gold certificates 
cannot fall below the value of gold coin, because for every 
dollar of such certificates there is a dollar's worth of gold 
coin or bullion in the United States Treasury, payable to the 
certificate holder on demand. The silver certificates are like- 



INTRODUCTORY ECONOMICS ^33 

wise secured in value by treasury holdings of silver. It is a 
part of the settled policy of the United States to maintain the 
silver dollars at a parity with gold ; and although no specific 
provision is made by law for the exchange of silver dollars 
for gold at the treasury, the privilege of making such an 
exchange would doubtless be accorded the holder of silver 
dollars if the latter showed any tendency to depreciate. A 
reserve of $150,000,000 in gold is held by the treasury for 
the purpose of redeeming any greenbacks that may be pre- 
sented for redemption. Any one who desires may exchange 
the lesser silver, nickel and copper coins for gold by present- 
ing them in suitable quantities at the treasury. 



CHAPTER XVI 
Financial Institutions : The Bank 

In a complex industrial society it is natural that there 
should be some men possessing capital who are unable or 
unwilling to employ it under their own management in busi- 
ness undertakings. Some men, while able to use part of 
their capital in the conduct of businesses under their own con- 
trol, are unable to use all of it advantageously. And some 
men, while able to use all their capital part of the time, fail 
to find use for it during some weeks or months of the, year. 
On the other hand there are men who have not enough capi- 
tal of their own for the proper exploitation of the oppor- 
tunities for its employment which they command. Some 
men, while having capital enough during the greater part of 
the year, require an additional amount during certain sea- 
sons. 

Accordingly one of the functions of the modern indus- 
trial organization is the transfer of capital from those who 
have a superfluity of it to those who can use it profitably. 
This function, which in view of the enormous amount of 
capital to be thus transferred is one of vast importance, may 
be designated by the term "finance." Institutions designed 
primarily to effect the transfer, or "placing," of capital are 
known as financial institutions. It is to be noted that we are 
here using the word "finance" in a sense in some respects more 
restricted, in some respects broader, than is usually conveyed 
by the term. But we are justified in this by the analogies of 
such words as "capital," "rent," "labor," etc., which have 
one meaning in economics and a slightly different meaning 
in popular language. 

The typical financial transaction, or transfer of capital, 
takes the form of a loan. A loan of capital may be effected 



INTRODUCTORY ECONOMICS 235 

by personal arrangement between lender and borrower, just 
as a sale may be effected by personal arrangement between 
producer and consumer. But just as the complexity of the 
conditions of the supply of and demand for commodities has 
rendered necessary the creation of a special commercial class 
and an elaborate commercial organization, as an intermediary 
between producer and consumer, so the conditions of the 
supply of and demand for capital have given rise to a finan- 
cial class, with highly developed financial institutions, as an 
intermediary between the man who has capital to lend and 
the man who desires to borrow it — or between the capitalist 
proper and the enterpriser. Of these financial institutions 
the bank is the most important. The placing of capital is 
indeed not the only function of the bank ; but it is its most 
important one, all other functions of the bank having grown 
up as accessories to the placing of capital. 

In its simplest form a loan is a transfer of a sum of 
money from one person to another, with the stipulation that 
at some future time, usually specified, an equivalent sum of 
money shall be repaid. The borrower naturally transforms 
the money thus obtained into goods at the earliest possible 
moment. If the goods purchased are designed for further 
production, the loan is virtually the transfer of capital. Such 
a loan is called a productive loan. If the money is spent for 
commodities for consumption, the loan is called a consumer's 
loan. The productive loan is by far the more common, and 
we shall concern ourselves chiefly with it. 

It is of course obvious that loans, whether productive 
or consumer's, will be made only to persons who have 
"credit," that is, to persons who are regarded as sufficiently 
honorable and efficient to be willing and able to repay the 
sums loaned when they fall due. A man's credit may rest 
upon his reputation for personal integrity and business ca- 
pacity ; more commonly it rests in part at least upon the fact 
that he has property which, under the law, can be seized by 
his creditors in case of default in payment of his debts. 



236 INTRODUCTORY ECONOMICS 

The agreement between creditor and debtor as to time 
of repayment, rate of interest, etc., may be merely verbal, as 
is said often to be the case in China, where the standards of 
business honor are extraordinarily high. In most modern 
states, such agreements are usually written, the borrower 
giving the creditor a promissory note, or written promise to 
pay a given sum at a specified date, with or without interest, 
as the case may be. Such notes are one form of "credit in- 
struments." If law or custom permits the creditor to trans- 
fer his claim upon the debtor to another person, the note is a 
"negotiable credit instrument," or "negotiable paper." 

The agreement between creditor and debtor may con- 
sist in the mere promise of the latter to pay, in which case 
the creditor relies for security upon the general effects which 
the debtor may possess at the time when the debt falls due. 
The borrower may, however, give more definite security to 
the lender by giving the latter a special claim upon some 
specific possession of the borrower, as a parcel of real estate. 
A note thus secured is popularly known as a "mortgage." 
The property given in pledge may not be alienated without 
the consent of the creditor until the debt has been extin- 
guished. 

Very frequently loans are disguised in the form of sales 
"on credit." The seller, instead of demanding spot cash for 
his wares, may agree to wait for a certain period of time — 
say, three months — ^before demanding payment. In this case 
the seller really lends the buyer a sum equal to the price of 
the goods. A company engaged in the manufacture of agri- 
cultural implements sells a self-binder to a farmer. The lat- 
ter has not the ready cash to pay for it, but expects to have 
the necessary sum four months later, when he sells his crops. 
He may borrow the money from a neighbor, giving his note, 
payable in four months, with interest. Or, instead of bor- 
rowing the money and paying cash for the machine, the 
farmer may buy it "on time," agreeing to pay for it at the 
end of four months. In this case we sometimes say that the 



INTRODUCTORY ECONOMICS 237 

farmer has purchased the machine with his credit. If we 
analyze the transaction into its elements, we shall see that this 
expression is inaccurate. The company has not merely sold 
the machine; it has also, in effect, loaned the farmer the 
money with which to pay for it. Every sale "on time" or 
''on credit" is a double transaction, involving a sale, in the 
proper sense of the word, and a loan of the capital repre- 
sented by the goods sold. It makes no difference whether or 
not the person who lends the capital is the same person who 
sells the goods. 

But the objection may be raised that the man who buys 
goods on time does not always agree to pay interest on the 
capital of which he has gained command through the pur- 
chase. This, however, is only apparently so. There is al- 
ways a difference between the credit price of goods and the 
cash price. This difference may be disguised under one 
form or another — as a discount, rebate, or what not — ^but it is 
always present. It represents interest, often at a very high 
rate, on the loan involved in the credit sale. 

We see then that a loan is involved in every credit sale ; 
and this is the distinguishing characteristic of such sales. 
We may with propriety extend the meaning of credit to all 
transactions involving loans. A man uses his credit in the 
same way whether he borrows money with which to buy 
goods or buys goods on time. A man who does business on 
credit is doing business on borrowed capital, whether he goes 
through the form of raising loans or not. 

There are some writers on economics who regard credit 
as a mysterious productive instrument, a form of capital, or 
at any rate a substitute for capital. The above illustration 
will show that this view has no justification. What the 
farmer cuts his wheat with is a capital good, embodying 
capital furnished either by his neighbor or by the agricul- 
tural implement company. This capital existed before the 
farmer gained possession of it, and would doubtless have 
been employed productively if the farmer had not decided 



238 INTRODUCTORY ECONOMICS 

to buy a machine. The fact that he buys the machine with 
borrowed capital shows that he beHeves that he can make 
this capital yield more than the interest which he must pay 
for its use. His "credit" enables him to procure capital 
to use in an emplo3^ment which he believes to be superior to 
the average in productivity. If he is right in his opinion, he 
is able to keep for himself a part of the product of this 
capital, as a profit. But the profit is not produced by his 
credit, any more than the wheat is cut by it. The profit is 
produced by the capital. 

Capital loans display wide variation in the length of 
time for which the lender loses control of his capital. Some- 
times the lender retains the right of calling for his capital at 
any time he desires ; sometimes the date when the debt falls 
due is fixed at thirty, sixty, or ninety days ; sometimes at five, 
ten, fifty years. This variation in the life period of loans 
is a reflection of the economic situation of the various classes 
of lenders and borrowers. 

At any given time there are men who have more capital 
than they need immediately ; they cannot tell, however, how 
soon they may need all they have. On the other hand there 
are men who can use capital profitably for an indefinite 
period of time, who can yet return it to its owner whenever 
it is demanded. Thus a man who deals in stocks and bonds 
may find exceedingly profitable employment for capital in the 
purchase of such securities when prices are rising. If he is 
operating with borrowed capital, he can sell the securities 
at any time when payment is demanded, and so restore the 
capital to its owner. 

Again, there are men who can safely part with the con- 
trol of their capital for a definite period of time — say, from 
one to six months. Corresponding with this class of lenders 
is a class of borrowers who cannot agree to pay off a loan on 
demand, but who are able to make arrangements for payment 
at a definite date some weeks or months after borrowing 
the capital. The merchant may serve as a type of this class. 



INTRODUCTORY ECONOMICS 239 

He may safely purchase a line of goods with the proceeds of 
a three months' loan, feeling quite sure that within the three 
months he will be able to sell the goods and so gain posses- 
sion of the means of repayment. 

Finally, there is a class of lenders who have no desire 
for the early repayment of their capital. With satisfactory 
arrangement made as to the rate of interest to be paid, they 
may be willing to transfer control of their capital for a period 
of ten, twenty or fifty years. There is a corresponding class 
of borrowers, who desire capital for investment in land, 
buildings, and permanent equipment, and who would be 
greatly embarrassed by the necessity of early payment. 

There are, then, three distinguishable sources of supply 
of loanable capital, and three corresponding sources of de- 
mand for it. In practical life, of course, with highly de- 
veloped financial institutions, there is a certain degree of 
interchangeability in the different funds of capital. Let us 
suppose that lenders of the first class make over their capital 
to a bank, reserving the right of withdrawing it at any time. 
Experience will show that while some lenders may withdraw 
their capital each day, new lenders will each day offer capi- 
tal at the bank. Thus the bank has a perm.anent fund of 
capital which it may lend to business men for stated periods 
of time. Men who wish to lend their capital for long periods 
of time may place it with a bank, which may use it in short 
time loans, experience showing that when one business man 
repays a loan of this kind another will be ready to borrow 
the capital. 

The bank proper is chiefly engaged in providing business 
men with demand and short term loans. The capital em- 
ployed in this way is in part the bank's own, and is perma- 
nently devoted to the purpose. By far the greater part of 
the capital, however, is supplied by other persons, who loan 
their surplus funds to the bank, receiving for the service 
either interest or some other form of compensation. Provi- 
sion for long term loans ifs usually made by various other 



240 INTRODUCTORY ECONOMICS 

financial institutions, such as the savings bank, the insur- 
ance company, the investment company, and the exchanges. 
These institutions will receive attention in the next chapter. 
Our present concern is the economic nature of the transac- 
tions in which the bank proper is engaged. 

Let us suppose that in a town of considerable size, not 
formerly enjoying banking facilities, a company is formed 
to establish a bank. An initial capital of $100,000 is sub- 
scribed. This capital consists, in the first instance, of cash. 
A part of the sum — say, $10,000 — is spent in erecting and 
equipping a building; the remaining $90,000 is placed in 
the vaults, to be loaned to business men who can give proper 
evidence of their ability to meet their obligations when due. 

As the bank has doubtless better means for keeping 
money safe than any other institution in the town, we may 
suppose that many persons will be glad to deposit with it 
any money which they do not immediately need, reserving 
the privilege of withdrawing it whenever they need it. On 
pay days salaried employees will deposit most of their 
month's earnings, expecting to withdraw the money day by 
day to meet their current expenses. Similarly capitalists 
will deposit their annual or semi-annual interest receipts, to 
be withdrawn in like manner for current expenditures. Mer- 
chants will deposit surplus cash which they will not need to 
reinvest in stock for some days or weeks. Lenders whose 
loans have been repaid will deposit the money until they 
find another satisfactory opportunity for lending. Thus a 
great part of the community will use the bank in greater or 
less degree for the storing of surplus funds. The sums so 
deposited are credited to the depositors on the books of the 
bank. 

The use of checks, or written orders for the transfer of 
funds, greatly increases the usefulness of the bank as a re- 
pository of funds of this kind. The depositor, instead of 
going in person to the bank to withdraw money for a pur- 
chase, may give the seller a check for the sum involved in 



INTRODUCTORY ECONOMICS 24I 

the transaction. The recipient of the check may present it 
at the bank for payment, carrying away the sum in money. 
If he is in the habit of depositing his own surplus funds in 
the bank, he is more likely to deposit the check, instead of 
cashing it. The sum called for in the check is then trans- 
ferred, on the books of the bank, from the account of the one 
person to the account of the other. Thus payment is effected 
without the handling of money by any one. When the check 
system is well developed funds deposited with the bank may 
change owners scores of times without ever leaving the 
vaults. 

The aggregate of cash entrusted to the bank may 
amount to a very considerable sum. At one time such de- 
posits may aggregate $50,000, at another time $75,000. Ex- 
perience may show that the volume of deposits never falls 
below $40,000. This sum of $40,000 may be regarded as a 
perpetual fund entrusted to the bank by the body of deposi- 
tors, although actual ownership of each part of it is continu- 
ally changing. 

The bank is, of course, under no obligation to keep in its 
vaults the money that has thus been entrusted to it. All that 
the bank is required to do is to hold itself in readiness to pay 
the money on demand. So long as it does this, it may use 
the deposits in any way that it may find profitable — observ- 
ing, of course, such restrictions in the use of its funds as the 
law prescribes. And this fact indicates the economic nature 
of such deposits. They are loans, payable on demand, the 
depositor being the creditor, the bank the debtor. 

Up to the present point we have been concerned with the 
bank as a borrower of capital. We have now to consider its 
position as a lender of capital. Let us suppose that one of 
the inhabitants of the town is a manufacturer of hardware, 
who sells his products "on time" to jobbers. This manufac- 
turer has sold, let us say, $10,000 worth of products, receiv- 
ing in lieu of payment notes for $10,000 at three months 
time. This means, as we have already seen, that the manu- 



242 INTRODUCTORY ECONOMICS 

facturer has made a disguised loan of capital to the jobbers. 
The manufacturer, however, needs his capital in order to con- 
tinue his business of manufacture. 

He may, if his credit is good, borrow $10,000 from the 
bank, agreeing to repay the loan in three months. In this 
case he is at the same time a lender of capital and a borrower 
of capital. The capital which he has loaned finds tangible 
form in goods in the possession of the jobbers. The capital 
which he has borrowed finds tangible form first in $10,000 
cash, then in the capital goods for which he exchanges the 
money. 

Instead of borrowing directly, he may sell to the bank 
the notes which he has received from the jobbers. When he 
has done this he is neither creditor nor debtor. The bank 
has become the creditor of the jobbers; its $10,000 of capital 
is no longer embodied in the goods which the manufacturer 
purchases with the money received from the bank, but in the 
goods in the hands of the jobbers. It is as if the manufac- 
turer had sold his wares to the bank, which in turn had sold 
them on time to the jobbers. 

For simplicity we have taken no account of interest. If 
the jobbers' notes bear no interest, the bank will not buy 
them for $10,000. It will deduct from the face value of the 
notes a sum representing interest for ninety days. This 
practice of deducting interest in advance is known as "dis- 
counting." A loan effected through the purchase of a note 
thus discounted is known as a "discount." If the manufac- 
turer offers his own note instead of the notes of the jobbers, 
it is of course discounted in the same way. 

At first sight it may appear that the manufacturer has 
suffered a loss by the transaction. The notes of the jobbers, 
representing purchases of $10,000, discounted at six per 
cent., net the manufacturer only $9,850. His own note, on 
which he would have to pay $10,000 on maturity, would net 
him an equal sum. We may be sure, however, that he 
charged the jobbers at least $150 more for his goods than he 



INTRODUCTORY ECONOMICS 243 

would have charged if they had been ready to pay spot cash. 
The jobbers, again, would not have submitted to the extra 
charge if they had not believed that the capital thus placed 
at their command would yield at least $150 in the three 
months. Or if the manufacturer obtains $9,850 from the 
bank on his own note, we may be sure that he expects that the 
capital in which he invests the money will earn at least $150 
in the three months. The "discount" which represents the 
gains of the bank is the product of its capital, either in the 
hands of the jobbers or in the hands of the manufacturer. 

Let us now suppose that the bank has loaned all its own 
cash in the way described. Will its operations cease for the 
time ? Not at all. For it has, we have assumed, a consider- 
able volume of cash deposits — other people's capital, en- 
trusted to it for safe keeping. On some days more of this 
cash may be withdrawn than is deposited, but experience 
may show that the excess of withdrawals never is more than 
twenty-five per cent, of the aggregate deposits. Why should 
not the bank lend the other seventy-five per cent., and thus 
get a profit out of it ? This in fact it would do. A manufac- 
turer, let us say, sells to the bank, or "discounts," jobbers' 
notes for $10,000. The bank buys the notes with its deposi- 
tors' money. Clearly enough, the capital at work in the 
business of the jobbers is, from an economic point of view, 
the capital of the depositors. The interest which the jobbers 
pay is, however, retained by the bank as a recompense for 
the trouble involved in keeping the funds of its depositors 
safe, and in effecting transfers of such accounts upon its 
books. 

The bank may find the business of lending the money 
of depositors so profitable that it will offer interest on 
deposits left with it for definite periods of time. It will of 
course pay a lower rate than it receives. In this case the 
earnings of the depositors' capital are divided between the 
bank and the depositors. 

When a manufacturer gets a note discounted at the 



244 INTRODUCTORY ECONOMICS 

bank he may, if he chooses, carry away with him the cash 
represented by the discounted value of the note. This, how- 
ever, he is not Hkely to do. What he wants the money for 
is to make purchases of materials, to pay salaries and wages, 
and to meet other business expenses. The most convenient 
method of payment is by checks drawn on the bank. So 
instead of carrying the money away from the bank he is 
likely to leave it as a deposit, subject to withdrawal on de- 
mand. Of course there is no reason why the bank should 
go through the form of counting out the cash to the manu- 
facturer if it is to be redeposited in this way. What it will 
do is to credit the manufacturer with the discounted value 
of the notes which he has transferred to it. It is easy to 
see that business men who transfer notes to the bank, 
whether their own or the notes of their debtors, will as a 
rule be satisfied if the bank will credit them with deposits 
represented by the discounted value of the notes transferred. 
It is in this way, not by the actual deposit of cash, that the 
greater part of the deposits of modern banks originates. 

We must now endeavor to disentangle the complicated 
relations of debtor and creditor involved in a deposit created 
in this way. The questions we must answer are these: 
Where is the actual capital which is producing the interest 
that the bank receives ; and who is, economically speaking, 
the ultimate lender of the capital? When the manufacturer 
sells to the bank jobbers' notes, the actual capital is invested 
in goods in the jobbers' possession. If the manufacturer 
redeposits the sum which the bank pays for the notes, he 
remains, for the time being, the ultimate lender of capital to 
the jobbers. He does indeed make over the interest to the 
bank, in return for the latter's guarantee that he may have 
his capital when he wishes it. In this respect his position is 
identical with that of the cash depositor, who permits the 
bank to enjoy the fruits of his capital on condition that he 
may withdraw it at will. 

Now let us follow, in imagination, the history of the 



INTRODUCTORY ECONOMICS 245 

manufacturer's deposit. After a few days he may draw 
checks aggregating $i,ooo in payment of salaries. These 
are deposited in the bank by his employees. The employees 
then become to the extent of $i,ooo the ultimate lenders of 
capital to the jobbers, the bank still keeping the interest paid 
by the latter. The employees may draw checks on the bank 
payable to their landlords; the latter then succeed to the 
place of lenders. And so the claim upon the jobbers may 
be passed from hand to hand for months. In the end, to be 
sure, some one may demand cash payment from the bank; 
the latter then assumes the role of ultimate lender, if it is 
compelled to draw upon its own cash. Very likely, however, 
the jobbers' notes have fallen due and the debts have been 
paid in cash, before the bank is called upon to assume the 
role of lender of its own funds. 

If the manufacturer sells to the bank his own note, and 
leaves the proceeds of the sale as a deposit, he is at once 
debtor to the bank for the value of the note and creditor of 
the bank for nearly the same sum. The bank's own capital 
plays no part in the transaction: the manufacturer is vir- 
tually his own creditor and his own debtor. No loan has 
really been made by the bank until the deposit is drawn 
upon. When the manufacturer draws on the deposit to buy 
materials the loan becomes a true transfer of capital, or eco- 
nomic loan. If the checks drawn by the manufacturer are 
deposited with the bank by the seller of materials, the latter 
becomes the ultimate creditor of the manufacturer. If the 
checks are cashed, the bank assumes this role, unless indeed 
it uses cash deposits for the purpose. 

In the foregoing discussion it has been assumed that 
the transfer of claims upon the bank is made through checks, 
drawn upon a deposit, and redeposited by the holder. A 
man who receives a check may, however, transfer it, prop- 
erly endorsed, to another man, who in turn may transfer the 
check to a third person. Each holder of the check becomes 
in turn the creditor of the bank, and through the bank the 



246 INTRODUCTORY ECONOMICS 

creditor of some business man who is using capital bor- 
rowed from the bank. When the check is at last deposited 
with the bank, the claim upon the bank is formally trans- 
ferred on its books. But it is obvious that the claim on the 
bank is just as certainly transferred whenever the check 
changes hands. 

Let us now suppose that the bank, instead of crediting 
the manufacturer with the discounted value of his note, 
gives him a parcel of its own promissory notes, representing 
the bank's promise to pay cash to the holder on demand. 
The manufacturer is then debtor to the bank for the amount 
stated in his note; he is the creditor of the bank for the 
amounts stated in the bank notes in his possession. As soon as 
he uses the notes for the purchase of supplies, etc., he trans- 
fers the claim upon the bank to the seller of the supplies. 
Such notes might pass from hand to hand for years, each 
successive holder of a note becoming the creditor of the bank, 
and through the bank, the ultimate creditor of some business 
man. 

Obviously it makes little difference to the bank whether 
the manufacturer in our example is credited with a deposit on 
the books of the bank in payment for his note or takes the 
bank's notes in the same sum. The deposit represents a right 
to cash on demand ; the bank notes represent exactly the same 
thing. The deposit may pass from owner to owner through 
checks drawn upon it and redeposited with the bank; the 
note passes from owner to owner without the formality of 
a transfer on the books of the bank. Any one of the series 
of owners of the deposit may demand cash at any time ; the 
same is true of any one of the series of holders of a bank 
note. For some classes of transactions, it is true, a deposit 
subject to check is the more convenient means of payment, 
while for other classes of transactions bank notes are the 
more convenient. 

It is often said that a bank loans not only its capital, 
but its credit also. If the student has followed the fore- 



INTRODUCTORY ECONOMICS ^47 

going analysis, he has seen that what the bank really lends 
is capital, and nothing but capital, either its own or that of 
other persons. Because its credit is good, men entrust it 
with their surplus funds, which it uses so as to gain a profit, 
by placing them at interest in the hands of business men. 

We assumed that the bank begins business with a capi- 
tal of $100,000, of which $90,000 consists of cash; further, 
that the surplus cash of the inhabitants of the town, amount- 
ing to at least $40,000, is deposited with the bank. Let us 
suppose that the bank lends $100,000, or, to use another 
form of expression, invests $100,000 in the notes of business 
men. These men, we have seen, will not care to take the 
cash from the bank's vaults, preferring to leave it on deposit. 
As these depositors draw upon the bank in the course of 
their business, some cash is withdrawn; for the most part, 
however, the checks are redeposited. So the bank will con- 
tinue to hold almost as much cash after making its loans as 
it had at first. Why should it not lend another $100,000, 
and another, and another? To do so will only slightly re- 
duce the amount of cash held by the bank, as the borrowers 
Vv^ill for the most part be content with deposits credited to 
their accounts. The deposits thus created may amount to 
$350,000 ; the original cash deposits, $50,000. Against this 
volume of deposits the bank may have only a little over 
$100,000 in cash. 

This would mean that the bank has borrowed $400,000, 
any part of which sum it must hold itself in readiness to 
pay on demand, although it has only $100,000 in cash. 
What if all its depositors should suddenly demand payment? 
The bank would have to suspend payment, of course. But 
as a matter of fact there is very little danger that the de- 
positors will all demand payment at once. As long as the 
credit of the bank is good, its depositors will draw from it 
only so much cash as they may need for minor business 
transactions ; and this cash for the most part finds its way 
into the hands of merchants, who redeposit it in the bank. 



248 INTRODUCTORY ECONOMICS 

Larger transactions are effected by means of checks, and 
these, we have seen, are as a rule redeposited. If the bank 
keeps in its reserves cash amounting to one-quarter or one- 
fifth of its demand obhgations, it will under ordinary cir- 
cumstances be in a position to meet promptly all demands 
upon it. How great the proportion of cash reserves to 
demand obligations must be, experience alone can tell. Each 
bank, within the Hmits of the law, must determine for itself 
how great a reserve it needs. 

Remote as is the chance that all the depositors, or any 
great part of them, will simultaneously present their claims 
upon the bank, there is always a possibility that the demands 
upon the bank may at any time reduce the cash reserve 
below the point of safety. If the credit of the bank is not 
impaired, it can usually replenish its reserve simply through 
refraining from making further loans. We must remember 
that the bank holds business men's notes exceeding in face 
value its volume of deposits. These notes attain maturity 
at different dates, but none of them, we may suppose, runs 
for a period of over three months. If then the bank col- 
lects when due the sums which it has loaned to business 
men, it will gradually restore its cash reserve, or at any rate 
reduce the volume of its outstanding obligations. In three 
months' time it will be able to pay all its depositors in full, 
without suffering any serious embarrassment. 

There are, however, circumstances under which the 
volume of demands upon the bank for cash is too great to be 
met in this way. It may be that a rumor has gone abroad 
that the failure of the bank is imminent, resulting in a 
''run" on the bank, a large number of depositors demand- 
ing their funds at once. If there are in the vicinity other 
banks the credit of which is unshaken, these may be willing 
to buy of the embarrassed institution some of the notes 
which it holds, and thus provide it with the cash it needs. 

It is obvious that the solvency of the bank depends upon 
the ability of its debtors to meet their obligations when due. 



INTRODUCTORY ECONOMICS 249 

If the notes which it holds are worthless, it cannot pay its de- 
positors at all. If the notes cannot be paid at the time 
agreed upon, the bank may have to suspend payment for a 
considerable period of time, and this would seriously im- 
pair its credit and so destroy its business. Sound banking 
requires that the utmost care be exercised in the making of 
loans. The business standing of each man who desires a 
loan is closely scrutinized. Loans are limited to short peri- 
ods of time, so that in case of need the bank's funds may not 
be long out of its control. Banks do sometimes fail to pay 
their creditors, through fraud or mismanagement. But this 
is a comparatively rare occurrence. 

While the funds of a bank may be invested almost ex- 
clusively in short time notes, this is not necessarily the case. 
Any kind of property that finds a ready sale and that is not 
subject to marked fluctuations of value may serve as a bank- 
ing investment. If the bank has funds invested in such 
property, it can recover them, through sale, whenever it finds 
this necessary. Tangible property does not answer the 
purpose, since such property fluctuates widely in value, and 
is often unsalable for a considerable period of time. The 
stocks of a great corporation can always find a market, but 
their value is subject to wide fluctuations. Corporation 
bonds are more stable in value, but not as a rule sufficiently 
stable for the purpose of bank investment. Government 
bonds, on the other hand, fluctuate in value only slightly, 
and always find a ready market. Accordingly it is quite as 
safe for the bank to invest in such bonds as in short term 
notes. But government bonds yield a very low rate of 
interest ; hence a bank is not likely to invest heavily in them, 
unless there is some special inducement offered to the banks 
to do so. 

Let us now assume that, instead of one bank in the town, 
there are several, which we may designate as A, B, C, etc. 
Some of the citizens of the town will deposit their funds 
with bank A, some with B, some with C. Often a man will 



250 INTRODUCTORY ECONOMICS 

use his check, drawn on bank A, in making a payment to a 
man who keeps his deposit with bank B or C. The recipi- 
ent of the check might of course take the check to bank A, 
obtain cash for it, and deposit the money with his own bank. 
It is more convenient, however, for him to transfer the 
check, by endorsement, to his own bank. The bank then 
credits him with the sum represented by the check, and 
assumes the trouble of collecting the sum from bank A. 
And so every day, we may suppose, checks drawn on bank 
A are deposited with banks B and C; checks drawn on 
these banks are deposited with bank A. At the end of 
each business day a clerk in the employ of bank A takes the 
checks drawn on B and C and presents them for payment 
at those banks. Similarly a clerk from bank B presents for 
payment checks deposited with that bank, drawn upon A 
and C, The student can easily see that such a method of 
settlement involves some waste of energy. While a clerk 
of bank A is presenting for payment at bank B checks 
drawn upon that bank, a clerk of bank B is presenting 
for payment at bank A checks drawn upon the latter bank. 
Money is being carried from A to B at the same time that 
money is carried from B to A. Obviously some method of 
balancing can be devised which will save the unnecessary 
labor and risk of thus carrying money to and fro. Espe- 
cially would this be necessary in a large city, where there are 
scores of banks. 

In every important banking center the banks form an 
association which provides a building or a hall known as a 
clearing house, where representatives of the several banks 
meet daily for the settlement of the claims of each bank upon 
the other banks. The claims of each bank upon all the 
others are set off against the claims of all the other banks 
upon it. When this has been done, it will be found that 
some of the banks have a balance in their favor, while others 
have a deficit to make good. Each debtor bank then pays 
a single lump sum, representing its indebtedness to all the 



INTRODUCTORY ECONOMICS 25 1 

associated banks; each creditor bank receives a lump sum 
representing the balance of its claims upon all the banks. 
By this method the transfer of cash from bank to bank is 
reduced to the lowest terms. 

Sometimes, of course, checks or drafts drawn on banks 
in other cities will be deposited with a bank. It is obvious 
that arrangements for the handling of payments between 
banks in different cities analogous with the arrangements 
just described for payments between banks in the same city 
may be made. These we shall consider in a later chapter. 

An illustration was given in the last chapter of the 
way in which a promissory note might serve as a substitute 
for money in effecting exchanges. It is easy to see how 
bank deposits and bank notes may serve as excellent sub- 
stitutes for actual money. A deposit, we have seen, is not 
a definite sum of actual money, kept safe in the vaults of a 
bank. It is a right to demand money at the bank. When a 
man pays for goods by means of a check drawn on such a 
deposit, he simply transfers his claim upon the bank. Such 
a claim may be transferred again and again, effecting scores 
of exchanges. A bank note, as we have seen, is a claim 
upon the bank differing only in form from a deposit. It, too, 
may pass from hand to hand, effecting exchanges. Much 
the greater proportion of the total volume of exchanges in 
a country like the United States is effected through the 
transfer of bank deposits and notes. 

The banking system of a country plays obviously an 
exceedingly important part in its economic life. It not 
only serves the important purpose of collecting capital from 
men who do not need it and of placing it in the hands of men 
who can use it productively, but it also furnishes what is 
now the more important element in the medium of exchange. 
Almost every business man has daily occasion to use the 
services of banks. Indeed, it is difficult to imagine how 
business on a modern scale could be conducted without the 
aid of a banking system. 



252 INTRODUCTORY ECONOMICS 

A banking system, however, cannot be conducted with- 
out certain risks, both to the banker and to the pubHc. The 
greater the aggregate of loans a bank can make, the greater 
the profit to the bank. But after lending its own capital, 
every increase in volume of loans is of course attended by 
a «orresponding increase in volume of deposits — obligations 
which the bank must meet on demand. If the volume of 
deposits becomes too great, there is danger that the bank 
will not be able to meet its obligations of payment on de- 
mand. When this happens, the credit of the bank is se- 
verely shaken, and its depositors are seriously inconveni- 
enced, at the very least. Moreover, a banker who is eager 
to expand his volume of loans is not likely to scrutinize the 
character of security so carefully as he should. Thus he 
may be led to lend the bank's capital, and other people's cap- 
ital as well, to men who will be unable to repay the loans. 
As a result the bank may fail and the depositors also be in- 
volved in ruin. 

It is accordingly natural that governments should 
make various regulations designed to insure the stability of 
the banking system. Such regulations usually prescribe the 
minimum cash reserve which must be held against outstand- 
ing demand liabilities. Thus some of the States require 
banks chartered in those States to maintain a cash reserve 
equal to fifteen per cent, of all deposits. The United States 
requires all banks chartered under federal laws — national 
banks — to maintain cash reserves equal to a certain pro- 
portion of their demand liabilities — deposits and notes. 
This proportion is fifteen per cent, in the lesser towns and 
cities and twenty-five per cent, in certain large cities, desig- 
nated as reserve cities. But three-fifths of the reserve of 
banks in the lesser cities may be placed on deposit in banks 
in the reserve cities ; one-half of the reserve of banks in or- 
dinary reserve cities may be deposited in banks in New 
York, Chicago and St. Louis. 

The issue of bank notes is usually carefully regulated 



INTRODUCTORY ECONOMICS 253 

by government, so as to safeguard the holder of notes 
against loss. Now, we have seen that the positions of the 
note holder and the depositor are quite analogous. Both 
are creditors of the bank ; both have a right to cash on de- 
mand. Why then should the government take greater pains 
to insure the note holder against loss than to insure the de- 
positor against loss? 

The depositor usually lives in the city in which the 
bank which holds his funds on deposit is established. He 
is therefore in a position to know something of the standing 
of the bank. If he has reason to believe that the bank is not 
well managed, he can at once withdraw his deposit. On 
the other hand, bank notes often find their way to distant 
cities. The holders of such notes can know nothing about 
the credit of the issuing bank. For this reason it is only 
just that their interests should be protected by the govern- 
ment. 

Various methods are employed by the different govern- 
ments to protect the note holder against loss. In some 
countries the volume of notes that a bank may issue is lim- 
ited to a certain proportion of the capital of the bank; in 
case of failure the note holders have a prior claim upon all 
the resources of the bank; furthermore, each bank is re- 
quired to contribute to a fund for the immediate payment of 
notes of banks that have failed. In the United States na- 
tional banks alone have the privilege of issuing notes ; other 
banks may indeed issue notes, but are taxed so heavily 
on all notes issued that issue is unprofitable. A national 
bank which avails itself of the privilege of issue must pur- 
chase, and deposit with the United States Treasury, United 
States bonds the par value and the market value of which is 
equal to the value of the notes issued. In case the bank fails, 
these bonds are sold and the proceeds used to redeem the 
notes. Thus it is quite impossible for the holder of bank 
notes to suffer any loss, even if the bank of issue fails. 



CHAPTER XVII 
Other Financal Institutions 

The chief function of the bank, as we have seen, is the 
supplying of the demand for short time loans, through the 
accumulation and placing of capital which is available for 
use for short periods of time. In the present chapter we 
shall study the mechanism by which the placing of capital in 
long time and permanent investments is effected. 

In order to gain an understanding of this mechanism 
we must endeavor to present to ourselves a general view of 
the sources of the demand for and the supply of free capital 
for long time investments. 

Throughout the country there is a constant demand for 
capital for the purchase and improvement of real estate. 
Men with small capitals of their own desire to buy farms or 
building lots; men who possess land desire to prepare it 
for cultivation or to equip it with the necessary stock or 
buildings. Those with insufficient capital — and they are 
many — enter the capital market as borrowers. They ex- 
pect such capital as they may raise through loans to be 
highly productive; but they cannot be sure that they will 
be able to restore it to the lenders for several years. To 
meet the needs of such borrowers, lenders must surrender 
control of their funds for a considerable period of time — 
five, ten or fifteen years. 

A second source of demand for capital arises from the 
needs of the modern large scale business enterprise. In 
many forms of business the capital necessary for effective 
operation exceeds the amount that an ordinary enterpriser 
owns, or can raise through personal loans. The number of 
million-dollar enterprises in the United States vastly ex- 
ceeds the number of millionaires. Accordingly there must 



INTRODUCTORY ECONOMICS 255 

be some method of transferring to a single active enter- 
priser the capitals accumulated by numerous individuals. 

A third source of demand for capital — and the last with 
which we need concern ourselves — arises from the extraor- 
dinary needs of government. Under ordinary circum- 
stances the expenditures of most governments are met by 
current revenues. Owing to unforeseen circumstances reve- 
nues may be less than was anticipated, while the expendi- 
tures may prove unusually heavy. As it takes time to 
revise a revenue system, a considerable deficit may appear, 
which involves borrowing under one form or another. 

A much more important cause of public borrowing is 
the enormous expense entailed by modern warfare. No 
great war can be carried to a successful issue without the 
employment of far greater resources than any practicable 
system of taxation will afford. Recourse must therefore 
be had to loans. Government loans thus arising cannot 
quickly be paid off. Often loans are negotiated for ten, 
twenty or thirty years; and even at the expiration of the 
period for which they are contracted, they are frequently 
paid out of the proceeds of new loans. The greater part of 
the public debt of the United States dates from the Civil 
War; a large part of the debt of Great Britain had its 
origin in the Napoleonic wars. 

Again, governments may borrow money for the pur- 
pose of carrying out a policy of permanent improvements. 
The United States, for example, raises the funds for the 
construction of the Isthmian Canal through loans. The 
Prussian, Russian, Indian and Australian governments bor- 
rowed vast sums for the purpose of purchasing and con- 
structing railways. Cities are continually borrowing money 
for similar purposes. Especially where the policy of muni- 
cipal ownership finds favor, the demand for capital for pub- 
lic use is enormous. 

We may now consider the sources of the supply of capi- 
tal for long time investment. Just as there are always men 



256 INTRODUCTORY ECONOMICS 

who are entering business life, so there are always men 
who are retiring from active business affairs. Men of the 
latter class desire to obtain an income from their accumula- 
tions without the labor that personal management entails. 
Universities, hospitals and other institutions receive money 
endowments, which must be invested in such a way as to 
yield a steady income. Thus some part of society's perma- 
nent fund of capital is continually requiring to be rein- 
vested. Further, the capital of society is steadily increasing 
through saving. Wage-earners and professional men are 
under the necessity of putting by a part of their incomes as 
a reserve against sickness and old age, or as a provision for 
their dependents in case of death. Capitalists who look 
forward to increasing burdens save some part of their in- 
terest receipts ; active business men save part of their profits. 
Of these savings some part is reinvested in their own busi- 
nesses by the men who save. A great part of the total 
fund of savings must, however, be placed under the control 
of other persons, if it is to yield a considerable income. 

We have now a view of the work that the financial 
mechanism must perform. It must gather together the 
funds of free capital and place them under the control of 
those who can make best use of such funds. We may next 
proceed to a study of the methods by which this work of 
placing capital is performed. 

The transfer of capital may assume the form of a loan, 
or it may assume the form of a partnership arrangement. 
To illustrate, let us suppose that a mine operator holds a 
lease of advantageously situated coal lands. To develop 
these lands he may need a capital of $100,000. A retired 
merchant in the vicinity has, we will say, $100,000 from 
which he desires to get an income without the labor of man- 
aging a business on his own account. The mine operator 
may borrow the $100,000, agreeing to pay a stipulated rate 
of interest. On the other hand, he may be willing to form 
a partnership with the owner of the capital, agreeing to 



INTRODUCTORY ECONOMICS 257 

share the profits in fixed proportions. In either case the 
capital is virtually placed under the control of the mine 
operator. From a legal point of view the distinction be- 
tween the two methods of transfer of capital is clear. If 
the transfer is effected through a loan, the mine operator 
becomes the legal owner of the goods in which the capital 
is invested, subject to the claims of the lender for interest 
and principal. The lender has no voice in the management 
of the business. If the transfer of capital is effected through 
a partnership agreement, the capitalist becomes part owner 
of all the capital goods employed in the business, and is 
entitled to a voice in the management of it. From an eco- 
nomic point of view, the chief distinction is that in case of 
a loan transfer of capital, the capitalist receives a fixed in- 
come, not affected by the vicissitudes of the business, while 
in the case of the partnership transfer, the capitalist re- 
ceives a share of the proceeds of the business, fluctuating 
with the alternation of prosperity and depression. The 
relation between the two methods of capital transfer will 
appear more clearly when we study them in their more 
highly developed forms — bonds and stocks. 

Where economic conditions are simple, as in an agri- 
cultural district or in a small town, the placing of capital 
may be effected through direct arrangements between those 
who need capital and those who have it to spare. The 
character and capacity of an enterpriser is easily ascer- 
tained by those who wish to place their capital. A man 
who wishes to borrow capital can easily establish relations 
with those who have capital to lend. Even in such simple 
conditions, however, the individual borrower or lender is 
often at a disadvantage. The former may fail to meet the 
men who are ready to lend at the lowest interest rate; the 
latter may fail to find the safest and most productive invest- 
ments for his capital. Hence the need for a middleman, to 
bring together borrower and lender, enterpriser and capital- 
ist. As industrial conditions become more complex, the 



258 INTRODUCTORY ECONOMICS 

need for the middleman becomes more intense. It would 
be quite impossible for the small capitalist of a city like 
New York or London to search out the most productive in- 
vestments afforded by the business of such a city, were there 
no men who made it their business to bring capitalist and 
enterpriser together. 

The men who perform this function may employ either 
of two methods. They may act as mere agents, in behalf 
of lender or of borrower or of both. Thus in some towns 
there are men who undertake, for a fee or "commission," 
to place any man who wishes to borrow in relations with 
men who have capital to lend. The function may, however, 
be performed in another way. Men with some capital of 
their own may hold themselves in readiness to borrow any 
capital that is offered for a definite period of time, trusting 
to the chance that they will be able to lend it again on more 
advantageous terms. The difference between the interest 
received and the interest paid represents the profits of the 
middleman. This, we have seen, is the method employed by 
the bank in its proper field. 

The distinction which we have drawn between the two 
methods of placing, or marketing, capital, finds its analogue, 
we readily see, in a similar distinction in the methods of 
marketing commodities. A manufacturer may employ an 
agent, at a fixed commission, to bring his wares before the 
consuming public, or he may sell them to a merchant, who 
undertakes the responsibility of disposing of them to con- 
sumers.. 

We have now a view of the primitive forms out of 
which the complex structure of the modern financial me- 
chanism has evolved. Capital may be transferred through 
loans or through partnership agreements ; the transfer may 
be effected through agents, or through the medium of men 
or of institutions who borrow of those who have capital to 
lend, in order to lend, on more advantageous terms, to thosg 
who have opportunities for the use of capital 



INTRODUCTORY ECONOMICS 259 

The transfer of capital implies the creation of various 
instruments which serve as evidence of the claims of the 
capitalist. The simplest type of such instruments is the 
promissory note given by the debtor to his creditor. Where 
the sum to be raised by a loan is very great, as in the case of 
corporation loans, the resources of numerous lenders must 
be drawn upon. Instead of executing a great number of 
separate notes, representing the amount borrowed from 
each person, the corporation may execute a note covering 
the whole sum and deposit it with a trustee. The trustee 
may then prepare certificates representing shares in the 
loan, and deliver them to lenders as evidence of the sums 
loaned. Such certificates are known as "bonds." A 
government may issue similar certificates of indebtedness 
without executing a note representing the entire loan. In 
any case it is clear that government and corporation bonds 
are merely forms of promissory notes. 

If money is to be raised through a partnership arrange- 
ment, the capitalist may receive, as evidence of his claims, 
a written instrument specifying his share in the capital of 
the business, and in the control of its operations. If a large 
sum is to be raised in this way, it is convenient to divide it 
into shares, represented by stock certificates, each entitling 
the holder to a definite share in the profits of the business 
and to a voice in its management. 

Such instruments — promissory notes, bonds and stocks 
—are clearly not capital, but merely evidence of ownership 
of capital. We may, however, think of the purchase and 
sale of such instruments as the purchase and sale of capital, 
since the ownership of the underlying productive goods is 
transferred with the transfer of such instruments. For con- 
venience we may speak of notes, bonds and stocks as "in- 
vestments." 

Investments of this character naturally differ widely in 
security and in productiveness. The long-period notes of 
business men are usually secured by the pledge of tangible 



26o INTRODUCTORY ECONOMICS 

property of some kind, but the property pledged may repre- 
sent a more or a less adequate guarantee of repayment. A 
loan secured by the pledge of land in the semi-arid region 
is not so safe as a loan secured by the pledge of land in a 
locality where crop failures are unknown. A series of dry 
years may depopulate a semi-arid district, and practically 
destroy the value of land there. Loans secured by subur- 
ban real estate are not as a rule so safe as loans secured by 
business property in the heart of a city. The bonds of a 
government like that of the United States are generally re- 
garded as far safer investments than those of Japan; the 
bonds of the latter country are safer than those of Guate- 
mala or Venezuela. Corporation bonds similarly vary 
widely in security. Experience has shown that corporations 
frequently fall bankrupt, in which case the bond holders may 
lose part or all of their invested capital. Stocks, as a rule, 
are yet more uncertain investments. When a new inter- 
urban railway is constructed, no one knows certainly that 
the business which it will carry on will yield a fair return on 
the capital invested; if it does not do this, dividends on its 
stocks will be low. Even in the case of an established busi- 
ness, changed conditions may annihilate profits and cause a 
suspension of dividend payments. 

The rate of return on such investments naturally varies 
widely. Personal notes, secured by mortgage, may vary in 
return from four per cent, interest to ten per cent, or more. 
Corporation bonds may vary from three per cent, to eight; 
government bonds from two to ten or more. Dividends on 
stock vary from nothing to fifty or sixty per cent, on the par 
value. In the case of loans of all kinds, the productiveness 
varies inversely with the security, or rather, with the popu- 
lar estimate of security. Turkish bonds yield a higher rate 
of interest than those of the United States, largely because 
no one knows how long the present Turkish constitution 
will stand. 

Investments further differ in transferability. Suppose 



INTRODUCTORY ECONOMICS 261 

that an investor in New York holds a note secured by a 
mortgage on a farm in one of the Western States. In some 
of the States such a note is not transferable at all. Even if 
the laws are such as to permit the sale of the note to a third 
party, the holder would find difficulty in disposing of it. 
The buyer would need to know something of the value of 
the property pledged as security, and this he might be un- 
able to ascertain without examining it himself. The bonds 
of a small manufacturing or mercantile corporation in one 
of the minor cities would more easily find buyers in distant 
financial centers. Even these, however, would ordinarily be 
difficult to dispose of. The bonds of a great railway or of 
an industrial consolidation always find a ready sale. One 
who invests in a Pennsylvania Railway or a United States 
Steel Corporation bond knows that he can at any time find 
some one who will be ready to buy it from him. 

As a rule, the greater the transferability of a form of 
investment, the lower will be its productiveness. Few in- 
vestors are absolutely certain that they will not at some time 
desire to regain control of their funds. They will therefore 
take at par a bond that is easily disposed of rather than one 
of equal security and equal productiveness which they might 
find difficulty in selling. Consequently, the price of bonds 
of the former class will generally be higher than that of 
bonds of the latter class. A hundred dollars invested in 
the former class of bonds will yield a lower rate of interest 
than a hundred dollars invested in the latter class. 

We may divide investments into two classes, those of 
a high degree of transferability and those of a low degree. 
Investments of the former class are specially adapted for 
those individuals who have funds of moderate size to invest. 
A small merchant, let us say, has retired from business, 
receiving for his store and stock $100,000 in cash. He 
may, if he likes, buy State or municipal bonds, which will 
yield him an income of $3,500 or $4,000. If later he wishes 
a larger income, and is willing to take some risks, he may 



262 INTRODUCTORY ECONOMICS 

sell his State or municipal bonds for very nearly the sum 
which he paid for them, and reinvest his capital in rail- 
way or industrial bonds, yielding $4,000 or $5,000. Or, he 
may buy railway or industrial stocks, yielding from $5,000 
to $7,000. The variety of such investments open to him is 
very wide, and if he is a good judge of market conditions 
he may be able to invest in highly productive securities with- 
out incurring a high degree of risk. 

In the purchase and sale of such securities the investor 
must employ the services of professional dealers, or 
''brokers," who execute orders on commission. If you have 
bonds or stocks which you wish to dispose of, you authorize 
a broker to find a buyer for you. If you wish to buy, you 
authorize the broker to find a seller. Naturally, the brokers 
dealing in stocks and bonds establish the custom of meeting 
at a fixed place, where those who have orders to buy may 
meet those who have orders to sell. Such a meeting-place, 
or market, is known, as a stock exchange. For convenience, 
each exchange makes rules which brokers doing business 
there must observe. In their details these rules do not con- 
cern us here ; in principle they are designed to insure effec- 
tiveness and fair dealing. 

Practically all the securities dealt in on the exchanges 
are constantly fluctuating in price. The bonds of a country 
like the United States are unusually stable in value, yet a 
hundred dollar bond is somewhat cheaper at one time than 
at another. If the United States should become involved in a 
war, the price of its bonds would decline, because of the prob- 
ability of new issues. Even the rumor of a war, however 
slight its foundation, hiay affect adversely the price of a 
nation's bonds. The bonds of a city may decline in value if 
the city government announces its intention of undertaking 
improvements on a large scale. The price of bonds of 
railway and industrial corporations is affected by every 
change in business conditions. Price fluctuation is still more 
common in the case of stocks. It is not unusual for the pric§ 



INTRODUCTORY ECONOMICS 263 

of a given stock to decline from $150 per share to $60 per 
share within a single year. Suppose that a company has 
been formed to exploit gold mines in Alaska. Its shares 
are offered on the market; we have read glowing accounts 
of the prospects of the company. It may earn enough to 
pay enormous dividends; it may earn nothing. What can 
be more natural than that opinion as to the value of the 
stock should fluctuate, and that the price of the stock should 
fluctuate accordingly? 

In view of the constant fluctuations in securities, it is 
natural that some men should make it their business to buy 
stocks when they appear to be cheap, with the purpose of 
selling them when prices rise. This is one of the numerous 
forms of speculation. The buyers of stocks and bonds are 
commonly divided into two classes^ — investors and specula- 
tors. The former class buy chiefly with the purpose of en- 
joying a permanent income from the securities purchased; 
the latter, chiefly with the hope of profiting from a rise in 
price of the securities. 

Naturally, the speculative buyer deals commonly in the 
securities that show great fluctuations in price, while the in- 
vestor prefers the securities that have a comparatively 
steady price. Now, it is the securities of new companies 
that are most likely to fluctuate in value. After a com- 
pany has been in operation for a number of years, its nor- 
mal earning power becomes established, and the real value 
of its securities becomes fairly well settled. Thus there 
is a constant progress of securities from the speculative class 
to the investment class. 

We can now see what one of the economic functions of 
stock speculation must be. So long as the success of a com- 
pany is in doubt, the cautious investor will have nothing to 
do with it. Men who are willing to take risks — speculators 
— buy the securities of such a company, with the expectation 
of selling them later at a profit. In so doing they furnish 
the company with the funds necessary for carrying on busi- 



264 INTRODUCTORY ECONOMICS 

ness operations. If the company succeeds, and demon- 
strates its power to produce a large and steady income, its 
securities acquire a stability of value fitting them for pur- 
poses of permanent investment. The speculators, in such 
case, gain large profits. In case the company is a failure, 
the speculator bears the loss. 

It is of course true that stock speculation offers great 
opportunities for sharp practice. A group of speculators 
holding the stock of a gold-mining company may succeed 
in placing in circulation deceptive accounts of the prospects 
of the company, and so manage to dispose of their holdings 
to the unwary at unreasonably high prices. A group of 
speculators, desiring to purchase certain stocks at a low 
price, may circulate rumors of impending disaster, and so 
create a panic among holders of stocks. Nevertheless, it is 
to be borne in mind that the speculative buyer of stocks per- 
forms a very important economic function in furnishing 
capital for enterprises the success of which is still in doubt, 
but which may eventually prove to be highly profitable. 
The speculator stands in the position of a middleman, be- 
tween the company which needs capital and the cautious 
investor. 

Where enormous sums of capital must be raised, an- 
other functionary may be inserted between the company 
needing capital and the individual speculator or investor. 
Let us suppose that a great railway desires to raise 
$50,000,000 by a new issue of four per cent, bonds. The 
bonds of that railway which are already outstanding may be 
selling above par. But no one can say exactly what effect 
on the price of bonds the new issue will have. Possibly the 
bonds will be taken by investors at par ; possibly the price 
will fall to $85 per hundred dollar bond. The railway 
company desires a definite amount of capital, and cannot 
afford to experiment. So its agents may make an arrange- 
ment with a group of financiers whereby the latter agree 
to insure the sale of the entire issue at $95 per hundred 



INTRODUCTORY ECONOMICS 265 

dollar bond. The bonds are then placed on sale at, say, 
$100. If the investing public takes the bonds at this price, 
the group of financiers, or "underwriting syndicate," gains 
a profit equal to the difference between the price to the 
public and the price agreed upon between the railway com- 
pany and the syndicate. If the public refuses to buy, the 
syndicate is compelled to take the issue of bonds at the 
price agreed upon — $95. Possibly the syndicate will be able 
to dispose of the bonds later on favorable terms ; possibly it 
will in the end be compelled to sell them at less than the 
price it has paid. 

Where the securities underwritten by a syndicate are 
of a more speculative character, as for example the stocks 
of a new industrial corporation, the difference between the 
price placed upon securities offered to the public and the 
price to the syndicate is much greater. The possible profits 
of the syndicate are much greater ; but so also are the pos- 
sible losses. 

We may now trace, in imagination, the course of the 
flow of capital from investor to enterpriser. A group of 
enterprisers desire to establish a great iron manufacturing 
business. They form a corporation with an authorized cap- 
italization, say, of $100,000,000. Stocks and bonds repre- 
senting this capitalization are prepared, and arrangements 
made with an underwriting syndicate, whereby the latter 
guarantees the sale of the securities at an average price of, 
say, $60 per hundred dollars of par value. The enterprisers 
can then proceed with their project of manufacturing, being 
assured of $60,000,000 in cash. 

The underwriters, of course, had no intention of per- 
manently investing $60,000,000 in the iron business. Pos- 
sibly the public does not at first care to take the securities, 
however, in which case the syndicate must make at least a 
temporary advance of the capital. 

As the company progresses with its operations, public 
interest is aroused. Speculators become convinced that the 



266 INTRODUCTORY ECONOMICS 

securities of the company will advance in value, and place 
orders with their brokers for such securities. After a time 
the syndicate has sold all its securities to speculators. These, 
then, are the persons advancing the capital to the company. 
With every report of the progress of the company the price 
of its securities changes. If the progress is unsatisfactory, 
the speculators who first purchased securities may lose heart, 
and sell at a loss to other speculators. If the company 
makes rapid progress, the first purchasers may sell at an 
advance, preferring to take profits rather than wait for still 
further advances. After the lapse of a few years, during 
which time the securities pass rapidly from one set of specu- 
lators to another, the earning power of the company be- 
comes established. It becomes generally known, let us say, 
that the company will be able to pay interest on its bonds 
and five per cent, on its stock. Gradually the prices of its 
securities become fairly stable, and these securities find their 
way into the hands of permanent investors. 

It is, of course, not inevitable that the flow of capital 
from permanent investor to active enterpriser should take 
such a roundabout course. A company may send circulars 
to persons who are believed to have capital to invest, offer- 
ing stocks or bonds at fixed terms. This method may be 
entirely satisfactory when the business of the company is 
already well established, and its reputation excellent. If 
the business is a new one and its results doubtful, the round- 
about method is more likely to be successful. 

We may now consider briefly certain institutions which 
place themselves between the investor and the enterpriser 
who seeks to raise capital, and which subserve especially the 
requirements of the small investor, who has not the time or 
the knowledge to form a correct judgment of the value of 
securities. 

A company may be formed for the sole purpose of deal- 
ing in the securities of other companies. Such a company — 
which we may call an investment company — ^places its stock 



INTRODUCTORY ECONOMICS 267 

upon the market, and invests the proceeds of the sales of 
such stock in the stocks and bonds of banking, railway, 
franchise and industrial corporations. The interest and di- 
vidends from such securities make up the gross profits of the 
investment company. From these profits are deducted the 
expenses of administering the company ; the remainder may 
be distributed among its stockholders as dividends. The 
advantages of such a company are obvious. It can employ 
men who are thoroughly familiar with the securities market 
to purchase stocks and bonds when the condition of the 
market is favorable. Since it purchases on a larger scale 
than the ordinary investor, it may participate in underwrit- 
ing syndicates, and so obtain securities at a much lower 
price than the outside investor must pay. It may distribute 
its investments so that when some of them fail to yield the 
expected returns, there may be a chance that others will 
yield unusually large returns. Thus the stockholders of the 
investment company are made more certain of a steady in- 
come than they would be if they invested their funds di- 
rectly. 

Further, the investment company may deal in securities 
of undoubted value, which are nevertheless not well enough 
known to be easily transferred. There is no reason why the 
investment company should ever part with such securities. 
It may purchase mortgage notes which never would find a 
purchaser on the general market; it may lend its funds di- 
rectly, with proper security. Now, the non-transferable in- 
vestments yield, as a rule, higher returns than those that 
are easily transferred. Accordingly, the man who invests his 
funds through an investment company may enjoy the higher 
income that non-transferable investments yield ; at the same 
time, he can at any time regain control of his funds through 
the sale of his stock in the investment company. 

From an economic point of view, the investment com- 
pany is a device which serves to direct capital to the more 
productive channels. In present-day business it has largely 



268 INTRODUCTORY ECONOMICS 

been diverted to another purpose — that of stifling competi- 
tion. Let us suppose that in a given territory two railways 
are actively competing for business. Neither can charge 
as high rates as it could if it enjoyed a monopoly. Now, 
let us suppose that an investment company buys up a major- 
ity of the stock of both railways. It may then appoint the 
directors of both railways, and require them to adopt poli- 
cies which enable each to fix high charges for service. In 
this way the earnings of the railway companies, and hence 
of the investment company^ are increased. Hostile federal 
legislation, it is true, has limited the efficacy of the invest- 
ment company as a means for destroying competition be- 
tween railways ; but the same device is widely employed in 
the case of manufacturing corporations. 

It is only persons possessing at least a moderate amount 
of free capital who can purchase with advantage investment- 
company shares. Persons who have no other resource 
than their daily labor need to save some part of their in- 
comes against sickness, old age or misfortune; and these 
savings should be placed where they may at once begin to 
earn interest. The artisan who saves $5 a month cannot be 
expected to keep the money on his premises until he has 
accumulated enough to buy a share of stock. This would 
involve keeping part of his savings idle for perhaps twenty 
months. It would, moreover, expose such savings to the re- 
current temptation to spend. Hence the need of an institu- 
tion which will accept savings deposits, however small, 
paying interest on them from the beginning, and which will 
return them to the depositor upon reasonable notice. Such 
an institution is the savings bank. 

Unlike the commercial bank, described in the last chap- 
ter, the savings bank can depend upon a certain permanence 
of deposits. Men who entrust their funds to such an insti- 
tution do so, as a rule, with the expectation of leaving them 
for an indefinite time, to earn interest. The savings bank 
may require its depositors to give some days' or weeks' 



INTRODUCTORY ECONOMICS 269 

notice of intention to withdraw deposits. Furthermore, in- 
terest may be allowed only at the end of six months' periods ; 
withdrawal at any time within such periods may involve 
the forfeiture of accrued interest. 

Some part of the deposits of a savings bank must be 
kept as a cash reserve, to meet possible withdrawals, but this 
reserve need not be so large as that of a commercial bank. 
The remainder of the deposits may be invested. State laws 
generally specify the classes of investments that a savings 
bank may make, with a view to insuring the depositor 
against loss through insecure investments. Real estate 
mortgages. Federal, State and municipal bonds, are the 
favorite investments of such institutions. The real estate 
mortgages present the advantages of security and a high de- 
gree of productiveness; government bonds, while yielding 
low returns, are easily convertible into cash whenever an 
unusual volume of withdrawals renders this necessary. 

Savings banks may be organized as mutual associa- 
tions, in which case all the profits from investments are dis- 
tributed among the depositors as interest. They may be 
organized as joint stock associations, the excess of earnings 
above stipulated interest to depositors being distributed 
among the stockholders as dividends. The latter form of 
organization prevails in the West, the former in the East. 
In foreign countries the place of the mutual savings bank is 
taken by trustee, municipal and postal savings banks. In 
general, it is recognized that the proper function of the 
savings bank is to promote thrift among the poorer classes, 
not to afford an opportunity for profit to the well-to-do. 
Hence the small depositor is frequently given the preference 
over the large depositor, receiving a higher rate of interest. 
In many cases the size of the individual deposit is narrowly 
limited. 

In recent years an institution has appeared which of- 
fers better opportunity for the deposit of large sums than the 
mutual or governmental savings banks can offer. This in- 



270 INTRODUCTORY ECONOMICS 

stitution is the "trust company." Persons having large 
funds of free capital may deposit them with a trust com- 
pany, receiving interest at a low rate, and retaining the 
privilege of withdrawal on demand. The trust company 
is usually, by law, granted far greater latitude in the invest- 
ment of its deposits than the savings bank enjoys. In many 
cases it may participate in syndicate operations, and so ob- 
tain securities more cheaply than most individuals could do. 
In any case it is in an excellent position to invest funds 
entrusted to it in highly productive ways ; hence it is able to 
pay large dividends to its stockholders while paying a rea- 
sonable rate of interest on deposits. 

A financial institution which in some parts of the coun- 
try takes the place of the savings bank in promoting saving 
among the working classes is the building and loan associa- 
tion. Each member of the association purchases a certain 
number of shares of "stock," paying for them in monthly 
instalments. If at any time he wishes to withdraw, the 
association returns to him the sums which he has paid in, 
with or without interest, according to the time that has 
elapsed since his first payment. If a member desires to build 
a house, he may borrow from the association a sum not 
exceeding the par value of the stock in the association which 
he holds. As security for the loan, he gives a mortgage 
upon the house which he builds with the aid of the loan. He 
further binds himself to make monthly payments to the 
association which represent interest on the loan, plus some 
part of the principal. Without entering upon the details 
of the organization of such an association, we can see that 
its purpose is to collect sums of capital from persons of small 
means, with the purpose of loaning them to other persons of 
small means who desire to own homes. The latter class 
pay the interest that the former class receive. 

One further institution requires notice here: the life 
insurance company. From a financial point of view, the life 
insurance company is a device for accumulating savings 



INTRODUCTORY ECONOMICS 27I 

which shall be returned, not to the man who saves, but to 
his heirs at his demise. Some of the insured, it is true, 
die long before the sum of the premiums they have paid 
equals the sum that the insurance company has agreed to pay 
at their deaths. On the average, however, the insured live 
long enough so that their premiums, together with the earn- 
ings of the capital which those premiums form, are at least 
equal to the sums which the insurance company pays out at 
the death of the insured. 

It is obvious that in a country like the United States, 
where life insurance is exceedingly common, immense sums 
of money must be collected by the companies every year, to 
be held as a reserve against death claims. As the business of 
life insurance is steadily growing, the funds representing life 
insurance reserves are also steadily on the increase. The 
annual receipts of practically every important life insurance 
company exceed the annual disbursements. Accordingly, a 
life insurance company may invest its reserves without much 
regard to the possibility of turning its investments into cash 
at short notice. It is important, however, that the business 
should be conducted in a conservative manner, since the fail- 
ure of an insurance company would be a more widely felt 
calamity than the failure of almost any other business enter- 
prise of equal magnitude. The loss would be borne in the 
end largely by the dependents of propertyless men. 

The reserves of life insurance companies are largely 
invested in real estate mortgages, in State and municipal 
bonds, and in the bonds of banking, railway, commercial 
and industrial corporations. Stock investments have been 
made by insurance companies, but the practice is now gener- 
ally regarded with disfavor, since the values of stocks are 
likely to show a wide range of fluctuation. 

It is to be understood, of course, that the various finan- 
cial institutions are all more or less closely interrelated. The 
insurance company and the savings bank may make use of 
the commercial bank and the trust company for the hand- 



272 INTRODUCTORY ECONOMICS 

ling of current funds. The trust company has played an 
important role in the underwriting of new issues of securi- 
ties, and so has taken direct part in the more speculative 
side of finance. Commercial banks, moreover, are increas- 
ingly important factors in the world of speculative finance. 
Individual speculators who anticipate a rise in the price of 
a certain stock buy not only as much as their own resources 
will permit, but also borrow large sums from the banks for 
the purpose of stock purchase. Thus some part of the 
fund of temporary capital is drawn into the field of perma- 
nent investment. 



CHAPTER XVIII 
International Trade and Foreign Exchange 

From early modern times, when men first began to 
think systematically upon economic subjects, a great deal of 
attention has been bestowed upon the exchange of goods 
between persons living under different governments, or in- 
ternational trade. It was for a long time believed (and it 
is still widely believed) that such trade differs radically in 
its nature from trade that is carried on within the limits of 
a single country. While the latter, it is generally admitted, 
is an unmixed good, and ought to be encouraged, or at any 
rate granted the most perfect freedom by government, the 
former, many believe, is often a doubtful blessing and ought 
to be closely scrutinized and regulated, and, under many cir- 
cumstances, discouraged or even prohibited. Whether there 
is any justice in this distinction between the two branches of 
trade is a question that we must defer to the next chapter. 
For the present, we are concerned with the conditions giv- 
ing rise to international trade and the mechanism by which 
it is carried on. 

All permanent exchange originates in differences in 
character of productive powers. To employ a simple ex- 
ample, drawn from the field of domestic trade, if A can 
make three pairs of shoes in a day while B can make only 
two, and B can cut two cords of wood in a day while A can 
cut only one, the basis for permanent exchange between 
them exists. It will pay A to get all his wood from B, 
exchanging shoes for it. The assumed difference in charac- 
ter of productive powers may have originated in differences 
in natural aptitudes or it may have originated in differences 
in training. In either case the difference in productive pow- 



274 INTRODUCTORY ECONOMICS 

ers is the essential basis of a continuous interchange of com- 
modities. 

But suppose that A can not only make more shoes in a 
day than B can make, but can also cut more wood. Does 
this supposition preclude the possibility of a permanent in- 
terchange of products between A and B ? Not at all. Sup- 
pose that A can make three pairs of shoes in a day or cut 
two cords of wood, while B can make only one pair of shoes, 
or cut only one cord of wood. With two days' work B can 
produce as much wood as A can with one; with two days' 
work he cannot produce as many shoes as A can with one. 
Accordingly, it would pay him to offer A the product of a 
little more than two days of his own work at woodcutting, 
in exchange for the product of one day of A's work at mak- 
ing shoes. And it would pay A to accept the offer. B 
suffers under a disadvantage in either occupation, but his 
disadvantage is less in woodcutting than in shoemaking. A 
enjoys an advantage in either occupation, but his advantage 
is greater in shoemaking than in woodcutting. Common 
sense, then, urges B to confine himself to cutting wood, A to 
making shoes. 

In the trade between inhabitants of one part of the 
earth's surface with those of another part, differences in 
personal aptitudes and training of the character assumed in 
the foregoing example are supplemented by differences of a 
more general nature. One region may have excellent min- 
eral deposits but lack fertile land for the growing of food; 
another region may be quite devoid of minerals, but abun- 
dantly supplied with rich lands. In one region the charac- 
ter of the population may be such as to fit it for kinds of 
work requiring skill and taste, but not such as to fit it for 
kinds of work requiring great muscular strength and endur- 
ance. In another region the population may be almost in- 
capable of acquiring taste and skill, although it is well fitted 
for labors demanding rude muscular power. Capital may be 
plentiful and cheap in one region and scarce and dear in 



INTRODUCTORY ECONOMICS 275 

another. In this case industries requiring vast capitals can 
be operated to greater advantage in the former region than 
in the latter. Land may be plentiful in one region, rela- 
tively to the population, and scarce in another. Industries 
requiring an extensive use of land will find their natural 
habitat in the former region. The populations of two re- 
gions, though differing little in fundamental character, may 
differ widely in their attitude toward particular forms of 
toil. They possess different habits, or, more properly, tra- 
ditions of workmanship, which fit the one better for one 
kind of labor, the other for another. So long as any of these 
differences persists, there is obviously reason why there 
should be differences in the industries of the two regions. 
With adequate means of communication, trade between the 
two regions naturally arises. 

We have spoken of differences between regions, not 
differences between nations. From a purely economic point 
of view, trade is either local or interregional, not do- 
mestic or international. The trade between Belgium and 
the adjacent departements of France is economically of the 
same character as the trade between Rhode Island and Mas- 
sachusetts. The trade between California and Hawaii is of 
the same essential character as the trade between New York 
and Santo Domingo. From an economic point of view do- 
mestic trade is that which originates in such differences in 
natural aptitudes and industrial training as may for a long 
time persist on the same soil. Differences in natural endow- 
ment, in general character of population, in rates of wages 
and interest, characterize interregional trade. As a rule, 
however, international trade is also interregional ; hence the 
principles that apply to the latter may without serious quali- 
fication be applied to the former. 

In some cases the products of two regions are quite 
dissimilar. Neither region can produce the commodities 
which it receives from the other. Thus in the Middle Ages 
an important trade was carried on between Northern 



2'](y INTRODUCTORY ECONOMICS 

Europe and the Indies. The former region furnished furs 
and amber, the latter, spices and gems. A modern example 
of the same sort of trade is the exchange of iron and steel 
products for teas, coffee and spices between England on 
the one hand and the East Indies on the other. In general, 
the trade between countries in the temperate zone and coun- 
tries in the torrid zone is largely of this character. Trade 
having this basis is naturally permanent; with every re- 
duction in costs of transportation it tends to increase. De- 
cline in railway and ocean shipping charges places more 
and cheaper tropical products in our hands, and places more 
of our products in the hands of the inhabitants of the tropics. 
Furthermore, we are, as a people, gradually learning to 
appreciate the good qualities in tropical products that a 
short time ago we held in slight esteem; and we may as- 
sume that a corresponding evolution is taking place in the 
tastes of the inhabitants of the tropics. 

More commonly one of the trading regions, or both, 
can produce both classes of commodities exchanged. The 
United States can produce both sugar and pork; so also 
can Cuba. But the United States possesses exceptional ad- 
vantages for the production of pork ; for the production of 
sugar it is not especially well adapted. Cuba, on the other 
hand, has unsurpassed advantages for the production of 
sugar, but can produce pork with only a moderate degree of 
success. It is, therefore, natural that an exchange of prod- 
ucts between the two countries should take place. Were 
there no artificial hindrances to such exchange, we should 
readjust our production somewhat, so as to produce more of 
the commodities that Cuba needs, and Cuba would devote 
more of her productive resources to the growing of sugar 
for our consumption. 

Differences in the essential character of the populations 
of two trading regions are difficult to define, since the char- 
acters of nations, as of individuals, are always thickly over- 
laid with custom and habit. Nevertheless, we may be quite 



INTRODUCTORY ECONOMICS 277 

sure that such differences exist. The German is not ex- 
actly the same kind of man as the EngUshman, even if due 
allowance is made for acquired traits. Still less is the 
Japanese the same kind of man as the American. It is 
therefore safe to assume that in some of the manifold 
branches of industry the German will be superior to the 
Englishman, while in some he will be inferior. We may 
certainly assume that in some branches of industry the Jap- 
anese will be more successful than the American, while in 
other branches he will be less successful. 

Cotton can be grown successfully by the native popula- 
tion of Central Africa. The tedious labor under a tropic 
sun is more easily borne by the native blacks than it would 
be by persons of European descent. The manufacture of 
cotton cloth by modern methods requires a higher degree of 
intelligence, perseverance and responsibility than the native 
population possesses. This branch of the industry may 
better be carried on in a country like England, where the 
population has the required traits in a high degree of de- 
velopment. Accordingly, there is a natural basis for per- 
manent trade between England and Central Africa. Trade 
based upon such essential differences in national character 
also tends to increase in importance with improvements in 
the means of transportation and communication. 

Trade based upon differences in relative supply of land 
attained extraordinary proportions during the nineteenth 
century. The Old World, for the most part, was densely 
peopled; in the New World population was sparse. It is 
a well-known fact that the largest output per workman of 
agricultural products is attained through the superficial cul- 
tivation of large areas. England may have lands that are 
naturally better adapted for the growing of wheat than the 
lands of Argentina. But one man cultivating twenty acres 
in England cannot possibly produce as many bushels of 
wheat as one man cultivating two hundred acres in Argen- 
tina. 



278 INTRODUCTORY ECONOMICS 

In manufactures, on the other hand, density of popula- 
tion, instead of reducing productive efficiency, tends to in- 
crease it. Men who Hve in constant association are better 
fitted for the organized activity of the modern factory than 
are men v^ho pass their Hves in the isolation of the frontier. 
Hence an exchange of agricultural products for manufac- 
tures between the New World and the Old was in the nat- 
ural order of events. 

During the greater part of the nineteenth century trade 
between the United States and England was chiefly of the 
character just described. The United States had vast tracts 
of land for extensive cultivation; England had a dense 
population well fitted for factory labor. Hence we exported 
foodstuffs and raw materials and imported manufactures. 

While trade upon this basis tends to increase with re- 
duction in costs of transportation, there is a countertendency 
at work which in time checks it. Immigration flows into the 
regions rich in land; the natural increase of population in 
those regions is likely to be rapid. In the end such regions 
lose their peculiar advantages in the production of foodstuffs 
and raw materials, and gain in power to produce manufac- 
tures cheaply. Trade of the character under discussion may 
continue for centuries, but ultimately it decays. The United 
States still exports large quantities of foodstuffs and raw 
materials, and imports manufactured goods. But these ele- 
ments in our foreign trade no longer maintain their former 
supremacy. In another century the United States will doubt- 
less import chiefly raw materials and foodstuffs from re- 
gions which remain sparsely peopled and export manufac- 
tures in exchange. 

We need not dwell at length upon the trade that is based 
upon differences in the supply and cheapness of capital. So 
long as England was par excellence the land of capital, and 
so long as English capitalists were unwilling to invest their 
funds in foreign lands, there were many branches of manu- 
facture that could be prosecuted with far greater advantage 



INTRODUCTORY ECONOMICS 279 

in England than in other countries. In practically every 
branch of manufacture, in fact, the interest on capital makes 
up a far larger proportion of the total expenses than in 
grazing, agriculture, lumbering, etc. It is easy to see, then, 
that English manufacturers, with interest at five per cent., 
enjoyed a decided advantage over American manufacturers, 
with interest at eight per cent. The English farmers and 
stockmen, it is true, also had an advantage in interest rates 
over their American competitors. But the advantage was of 
less relative importance and more easily offset by other 
factors in which the Americans enjoyed an advantage, such 
as cheaper land. 

Under present-day conditions no country can long hold 
a branch of trade merely through cheapness of capital. Like 
labor, capital tends to migrate to the less developed regions 
of the world ; its migration involves far less personal sacri- 
fice and far less cost. Furthermore, capital increases rapidly 
in the newer lands. If interest rates were much higher in 
the United States than in Great Britain, British capital would 
steadily flow into the former country ; and this influx of cap- 
ital, added to the new capital constantly accumulating here, 
would tend to depress interest rates, until there remained no 
perceptible difference in the rates prevailing in the two coun- 
tries. The trade based upon differences in capital supply 
may, therefore, be regarded as transitory. 

In a region that has long been devoted chiefly to a given 
branch of industry, something that we may call a tradition 
of workmanship evolves. The best type of iron worker is 
not developed in a single generation. The mill that is 
manned with workers whose fathers and whose fathers' 
fathers were reared in a world of iron manipulation possesses 
a decided though indefinable advantage over the mill that 
is manned with workers whose antecedents were of the field 
or forest. Costly experiments in settling urban stock upon 
farms have demonstrated the soundness of the popular view 
that it takes generations to make a farmer. Still more im- 



28o INTRODUCTORY ECONOMICS 

portant is the tradition of workmanship in industries requir- 
ing a high degree of taste and skill. Where is the Occiden- 
tal who can produce a true Oriental rug? 

When other conditions are ripe, the population of any 
region may develop the tradition of workmanship necessary 
for the successful prosecution of any specific branch of in- 
dustry. But no region can be expected to gain a superi- 
ority in all lines. We may at some future time be able to 
make gowns as well as the French, and ivory toys as well as 
the Japanese. But there will always be objects of taste 
which we must buy from the French and the Japanese. 
Trade based upon such differences may, therefore, be treated 
as permanent in character. 

In the foreign trade of a great country like the United 
States or Great Britain, it is natural that we should find 
one part having one underlying basis, another part another 
basis. In many cases the exportation or importation of a 
commodity arises from a combination of several of the causes 
which we have described as bases of trade. The exporta- 
tion of iron and steel products from Great Britain to India 
is based upon the fact that Great Britain has vastly superior 
deposits of iron ore and coal, cheaper capital, and a popula- 
tion better fitted than that of India for metallurgical industry 
and possessing a superior tradition of workmanship. The 
exportation of wheat from the United States to England is 
based solely upon the greater abundance of land, relatively 
to the population, in the former country. The importation 
into the United States of French articles of taste may be due 
in part to superiority of the French national character, in this 
respect; but it is undoubtedly due in large part to a su- 
perior tradition of workmanship on the part of the French. 

We have, hitherto, considered only cases in which each 
one of two trading regions possesses unique, or at any rate 
superior, advantages in the production of the commodities 
which it exports. Under certain conditions trade may be 
advantageous even when this is not the case. To use a 



INTRODUCTORY ECONOMICS 281 

time-honored illustration, let us suppose that the United 
States,, by reason of its natural wealth and the character of 
its population, is in a better position to produce both wheat 
and steel than England. A day's labor will produce more of 
either commodity in America than in England. Yet it may 
be profitable for the United States to buy its steel from Eng- 
land, giving wheat in exchange. We will assume that in 
America a day's labor will produce four bushels of wheat or 
two hundredweights of steel, while in England a day's labor 
will produce one bushel of wheat or one hundredweight of 
steel. Disregarding the costs of transportation, it would be 
profitable for America to offer England three bushels of 
wheat in exchange for two hundredweights of steel, and it 
would be profitable for England to accept the offer. America 
would thus obtain two hundredweights of steel for three- 
fourths of a day spent in wheat growing, instead of spending 
a whole day's labor in making the steel. England would 
obtain three bushels of wheat through two days' labor spent 
in steel making, instead of spending three days' labor in 
producing the same amount of wheat. America possesses 
an advantage in either industry, but her advantage is greater 
in wheat growing. England is at a disadvantage in either- 
branch of production, but her disadvantage is less in steel 
making. It is, therefore, natural, under the assumed condi- 
tions, that America should make a specialty of wheat pro- 
duction, England of steel making, and that the two countries 
should carry on a mutually profitable trade. 

This case is obviously analogous with the case of ex- 
change between shoemaker and woodcutter which we em- 
ployed in the early part of this chapter. But while any 
person of ordinary intelligence can see how it may be prof- 
itable for an efficient shoemaker to hire a man less fitted 
than himself for woodcutting to supply him with wood, it 
appears to be beyond the comprehension of most ordinary 
men, and many extraordinary ones, that a country can profit- 
ably pursue the same business policy. Since a day's labor 



282 INTRODUCTORY ECONOMICS 

does actually produce more steel in the United States than 
in England, many men believe that it must be unprofitable 
for us to buy steel from England. Obviously, they fail to 
consider the possibility that wq may have other industries 
so much more productive than those of England that we can- 
not afford to divert our labor to the making of steel. 

Let us look at the matter from another point of view — 
that of prices and money cost of production. The men who 
engage in the business of importing and exporting commodi- 
ties do not inquire into underlying bases of trade. Their 
inquiries begin and end with prices. Is steel cheaper in 
England than in America? If so, and if the difference is 
great enough to pay the cost of transportation, they import 
the steel, unless they are prevented by government from 
doing so. Is wheat cheaper in America than in England? 
If it is enough cheaper to pay the costs of transportation, 
they export it. 

But why should steel be cheaper in England than in 
America, while wheat is cheaper in the latter country? 
Prices, we know, tend to equal money cost of production ; 
therefore we may assume that it costs less to produce steel 
in England, wheat in America. Our inquiries cannot stop 
here, however, for we must know why it costs more to pro- 
duce the one commodity in the one country, the other com- 
modity in the other country. 

Ask a steel manufacturer why it costs more to produce 
steel in this country than in England, and he will probably 
reply, "Labor is dearer." The pay of English steel workers 
is, indeed, lower than that of steel workers in America, but 
so also is the pay of English agricultural laborers lower than 
that of farm hands in America. It is, therefore, plain that it 
is not the low wages, absolutely considered, that give the 
British steel manufacturer an advantage, but the low wages, 
relatively to the high productive efficiency of the workmen. 
Low wages do not make British agriculture prosperous, be- 
cause the productive efficiency of laborers in that industry 



INTRODUCTORY ECONOMICS 283 

is low, relatively to wages. The disadvantage of the British 
steel industry as compared with the American is less than 
the disadvantage of British agriculture as compared with 
American. 

We shall get a clearer view of the situation if we stop to 
consider the principles determining cost of production. 
Wages and interest are the chief constituents of cost of pro- 
duction; but we will fix our attention upon wages alone. 
In earlier chapters we saw that wages are determined by 
the marginal productivity of labor. Now, let us suppose 
that one trading region has a vast extent of fertile land and 
a sparse population. Only the best lands are tilled and 
these in a superficial way. Add a thousand laborers to the 
population. How much can they produce? Perhaps five 
bushels per man a day. This amount of wheat, or the price 
of it, they can demand as wages; all other equally efficient 
workmen will get as much, but no more. Another trading 
region has, let us say, a dense population and little land. 
All the good lands are carefully tilled; most of the poor 
lands are also under cultivation. Add a thousand men to the 
working population. It is highly improbable that these men 
will increase the product by five bushels per man per day. 
Rather, we may assume that the daily product of a man is 
only one bushel. And this, or its price, is all that any 
equally efficient laborer in the society can get. 

If the two regions are in easy communication with each 
other, the price of wheat in the one will be the same as the 
price in the other, allowance made for the cost of shipping 
wheat from the one to the other — a few cents per bushel, we 
will assume. This means that money wages will be much 
higher in the region which is sparsely settled than in the 
region where population is dense. 

Now let us suppose that each region possesses ores and 
coal, but that the deposits of the sparsely settled region are 
so much the richer that a day's labor will produce from them 
twice as much steel as a day's labor will produce from the 



284 INTRODUCTORY ECONOMICS 

deposits of the densely settled region. Enterprisers of the 
former region will have to pay miners, furnacemen, etc., at 
least as much as they could earn in agriculture — the price 
of five bushels a day. Enterprisers in the region of dense 
population will also pay wages gauged by the returns to 
agricultural labor — ^the price of one bushel a day. A simple 
calculation will show that steel manufacturers in the region 
of dense population can produce steel much more cheaply 
than their competitors in the other region. 

In order to make our example correspond more closely 
with reality, we should need to substitute, for steel making 
only, a wide range of industries, mainly manufacturing ; for 
wheat raising we should substitute a wide range of indus- 
tries, mainly extractive. We might then say, with perfect 
truth, that in a sparsely settled land the marginal productiv- 
ity and consequently the wages of labor are likely to be so 
high that manufactures cannot be carried on profitably in 
competition with a densely settled land, where the marginal 
productivity of labor, and hence wages, are low. American 
manufacturers of iron and steel products have for a century 
been forced to pay higher wages than English manufac- 
turers, largely because the productivity of labor in agricul- 
ture was so much higher here than in England. 

We have now to consider the mechanism whereby the 
exchange of goods between trading regions takes place. In 
early times, interregional trade, like all other forms of trade, 
was carried on through barter. The Phoenician merchant, 
we may safely assume, carried to each port commodities that 
he thought would be in demand there, and bartered them for 
commodities which he desired. In a later stage money was 
employed, but chiefly for effecting exchanges within a single 
locality. The artisan merchants of the mediaeval Hanse towns 
trading with England carried cloth and other wares to 
London and exchanged them for wool and other English 
products. Doubtless when in England the Hanse merchants 
often first exchanged their v\^ares for the local currency, and 



INTRODUCTORY ECONOMICS 285 

exchanged the currency in turn for goods to carry back to 
Germany. From the point of view of the two trading 
regions, the trade was an exchange of goods for goods, in 
spite of the employment of currency in England. 

In a later stage the importation of goods is partly di- 
vorced from the exportation of goods. Men having goods 
that they believe will fetch a high price in a foreign market 
ship them abroad, expecting to receive the price of the goods 
in the form of gold and silver. Men wishing to buy foreign 
goods send gold and silver in payment for them. Hence, 
exportation and importation of the precious metals may be 
often carried on concurrently, at a considerable risk and 
expense. Here obviously is opportunity for the develop- 
ment of a system of set-offs, to reduce the transmission of 
the precious metals between two trading regions to a mere 
settlement of balances. This mechanism, which long ago 
attained perfection, we shall now describe in its essential 
elements. 

Let us suppose that A, a New York exporter, has sold 
10,000 bushels of wheat to X, a Liverpool importer, at the 
price of $1 a bushel. If he wishes the $10,000 delivered to 
him at New York, in gold, he must, of course, pay freight 
and insurance on it. This will cost about $3 for every $500, 
or $60 for the entire sum. 

But suppose that after shipping the wheat, and before 
giving orders for the delivery of the gold, he meets B, a 
New York importer, who is about to order $10,000 worth of 
woolen goods from Y, a Liverpool exporter. If B were to 
ship the $10,000 in gold to Liverpool, it would cost him 
$60 for freight and insurance. Now, if A will give B an 
order instructing X to pay Y the $10,000, instead of re- 
mitting it to himself, B can pay A the $10,000 that he would 
otherwise have remitted to Y. Both debts will be extin- 
guished by such an arrangement, and both A and B can save 
$60 by it. 

Such an order as we have assumed that A gives to B| 



286 INTRODUCTORY ECONOMICS 

requesting- X to pay Y a Certain sum originally due to A, 
is known as a bill of exchange. Such a bill may be payable 
as soon as it is presented to the person upon whom it is 
drawn, or it may be payable after the expiration of a period 
of time — twenty, thirty, sixty days. In the former case it is 
a "sight bill," in the latter a "time bill." Time bills usu- 
ally bear interest — a fact that assimilates them to other 
credit instruments, but has no bearing on the principles of 
exchange. We shall therefore assume that bills of exchange 
are sight bills only. 

In our example it appeared that both A and B "gained 
$60 by the arrangement. Now, if B had been unwilling, 
for some reason, to give A $10,000 for the latter's bill of 
exchange, A might have taken less. It would have been 
more profitable for him to take $9,950 than to incur the 
expense of importing the gold. If B had offered $9,940, it 
would have been a matter of indifference to A whether he 
sold his bill to B or imported the gold. $9,940 is evidently 
the very lowest price at which the bill would be sold at all. 
On the other hand, if A had been unwilling to part with his 
bill for just $10,000, B might have offered more, for he 
could better have afforded to pay $10,050 for the bill than 
stand the expense of exporting gold. If A had demanded 
$10,060, it would have been a matter of indifference to B 
whether he bought the bill or shipped the gold. $10,060 is 
then the very highest price that a $10,000 bill can be made to 
fetch. 

When a bill of exchange sells for just its face value, it 
is said to be at par; when for more or less, it is above or 
below par. We have now to inquire under what conditions 
bills will be at par, or above or below par. 

If the importer whom we designated as B thinks that 
the chances are good that he can find other exporters besides 
A who are anxious to dispose of bills of exchange, he is 
likely to offer less than par for A's bill. If one of the 
holders of bills will not sell at a low price, another probably 



INTRODUCTORY ECONOMICS 287 

will. If, on the other hand, A thinks that he can easily find 
Other persons besides B who have payments to make abroad, 
and who are anxious to purchase bills for the purpose, he 
is likely to hold his bill at a price above par. In general 
terms, when the volume of bills offered for sale appears to 
exceed the volume of remittances to be made to a foreign 
center, bills fall below par. When the volume of bills ap- 
pears to be inferior to the volume of remittances to be made, 
bills rise above par. In the former case, each holder of a 
bill knows that some bills cannot be sold at all ; their holders 
will have to go to the expense of importing specie. Rather 
than be left in this position himself, he is willing to sell his 
bill at less than its par value, provided that the price offered 
is not so low that to bear the cost of importing specie would 
be a lesser evil. In the latter case each person having remit- 
tances to make knows that some men will have to go to the 
expense of exporting specie. Hence each one will offer more 
than its par value for a bill of exchange. 

If the volume of bills to be sold just equals the volume 
of remittances to be made, it is easy to see that bills must 
sell at par. 

We must now endeavor to determine the conditions 
under which the volume of bills equals, is superior to, or 
inferior to, the volume of remittances. We shall assume 
that the relations between the United States and Great Brit- 
ain are carried on without regard to relations with other 
countries, and that American business is all handled through 
New York, British through London. 

The United States, we will assume, exports in one year 
products worth $300,000,000 to Great Britain, and Great 
Britain exports products worth $200,000,000 to the United 
States. Under the head of exports and imports, we shall 
have bills on London aggregating $300,000,000, and remit- 
tances to make aggregating only $200,000,000. 

Citizens of the United States still owe vast sums to 
citizens of Great Britain; citizens of Great Britain owe 



288 INTRODUCTORY ECONOMICS 

lesser sums to citizens of the United States. Interest on 
these debts will be transmitted by way of exchange. Let 
us say that Great Britain must pay us $5,000,000 while we 
must pay Great Britain $25,000,000. This will add $5,000,000 
to the total volume of bills, and $25,000,000 to the aggregate 
of remittances. 

Some American borrowers are paying off their debts to 
British capitalists ; others are borrowing fresh capital. The 
sum of payments at present probably greatly exceeds the 
sum of new loans. We will put the former at $50,000,000, 
the latter at $25,000,000. Under this head, then, we may 
add $25,000,000 to the volume of bills, $50,000,000 to the 
volume of remittances. 

Americans living or traveling in England must have 
their incomes sent them from here; Englishmen living or 
traveling here must have their incomes sent from England. 
Let us suppose that we must send $15,000,000 to our citizens 
in England; England must send $5,000,000 to her citizens 
here. This would add another $5,000,000 to the volume of 
bills, $15,000,000 to the volume of remittances. 

Most of our trade with Great Britain is carried on by 
British ships. We must, of course, pay for the service, and 
our payments must be sent to Great Britain. We will place 
the aggregate at $75,000,000. What we carry for Great 
Britain is too little to take into account. So we must add 
$75,000,000 to the volume of remittances without any 
offsetting increase in the volume of bills. 

DUE THE UNITED STATES DUE GREAT BRITAIN 

Exports $300,000,000 $200,000,000 

Interest 5,000,000 25,000,000 

Proceeds of new Repayment of old 

loans 25,000,000 loans 50,000,000 

British travelers' ex- American travelers' 

penses 5,000,000 expenses 15,000,000 

Payment for ocean 

transportation 75,000,000 

l335»ooOfOOO $365,000,000 



INTRODUCTORY ECONOMICS 289 

Footing up the assumed items of indebtedness, we 
find that the United States can draw bills to the amount of 
$335,000,000, but must make remittances to the amount of 
$365,000,000. Obviously, exchange on London will be above 
par under the conditions. Any or all of the items may change 
before the end of another year, so that the balance will incline 
the other way. 

For simplicity we assumed that the exchange relations 
between the United States and England were not rendered 
more complicated by relations with other countries. This 
assumption we must now abandon. The United States buys 
coffee from Brazil. Brazil buys manufactures from England. 
England buys wheat from the United States. Now, it is evi- 
dent that Brazilian coffee exporters will be glad to accept 
from American importers bills of exchange drawn on Lon- 
don, as these bills will be in demand among Brazilian im- 
porters of British manufactures. 

If the sums that Americans must remit directly to 
England aggregate $300,000,000, and the sums that Eng- 
land must pay directly to the United States aggregate 
$325,000,000, bills drawn on London may yet be above par. 
For*^ American coffee importers may need, say, $40,000,000 
in bills on London to make payments in Brazil. In this 
case, the remainder of the volume of bills will not be suffi- 
cient to meet the demand for them, and they will go above 
par. 

Even if the Brazilians imported nothing from England, 
bills drawn on London would nevertheless be acceptable to 
them as means of payment for their exports. Brazil must 
import from some country, and that country, in all probabil- 
ity, has payments to make in England, and so will accept 
bills on London in preference to gold. This follows from 
the fact that England has for a century been the financial 
and commercial center of the world. The whole world deals 
with England. Hence bills of exchange drawn on London 
have become a favorite medium of international payments 



290 INTRODUCTORY ECONOMICS 

throughout the world. If you wish to remit money to a 
missionary in China or to a stockman in Patagonia, you will 
probably do it through exchange on London. Similarly, 
if Chinese or Patagonians have remittances to make to you, 
they will employ exchange on London for the purpose. 

Accordingly, the demand for bills on London is prac- 
tically equal to the whole volume of payments to be made 
by Americans to persons living outside of the United States ; 
the supply of bills amounts practically to the aggregate 
payments to be made by such persons to Americans. When 
we must pay foreigners exactly as much as they must pay us, 
exchange on London is about at par. When the balance 
of payments is in our favor, exchange is below par; when 
the balance is against us, it is above par. Naturally, ex- 
change on London is expressed in terms of the British 
currency — pounds sterling. When exchange is at par, the 
pound sterling is quoted at $4.86f. When exchange is 
above par, an American who wishes to remit a pound ster- 
ling to England must pay more than $4.86f for it — perhaps 
$4.88. If the price of a pound sterling (exchange) rises 
above $4.89!, it pays better to ship gold. The point at 
which all advantage in employing bills of exchange instead 
of gold ceases, is known as the gold point. If the price of 
the pound sterling declines to $4.83!, it pays holders of 
bills to send them over to England for collection, with orders 
that the gold be shipped to America. $4.83! is therefore also 
known as a gold point. 

If we assume that other items of international payments 
(transmission of capital, interest payments, travelers' ex- 
penses, payments for ocean transportation) remain con- 
stant, it follows that fluctuations in exchange follow fluc- 
tuations in exports and imports. If we increase our exports, 
imports remaining unchanged, the supply of bills increases, 
and their price tends to fall. If we increase our imports, 
exports remaining the same, the volume of remittances to 
be made increases, and exchange rises in price. 



INTRODUCTORY ECONOMICS 29I 

Now, when bills are above par it is more than usually 
profitable to export goods. Let us suppose that in New York 
the price of wheat is ninety-four cents a bushel, while in 
England the price is $i. If it costs five cents a bushel to 
ship wheat from New York to England, the exporter will 
make $ioo on a 10,000 bushel shipment, if exchange is at 
par. If exchange is at its maximum above par, the exporter 
will be able to sell his $10,000 bill for $10,060, thus adding 
$60 to his nominal profit of $100. If exchange is at its mini- 
mum below par, the exporter can get only $9,940 for his 
$10,000 bill, thus losing $60 of his nominal profit of $100. If 
a profit of $100 on 10,000 bushels is just sufficient to induce 
exporters to ship wheat, no wheat will be shipped if ex- 
change is below par. 

When exchange is below par, it is more than usually 
profitable to import goods. Let us suppose that it barely 
pays to import a certain kind of woolen goods when ex- 
change is at par ; that under these conditions the importer 
makes only $100 on a $10,000 shipment. If exchange is 
at its lowest price the importer can pay for his goods with 
a $10,000 bill costing only $9,940. Thus he adds $60 to his 
profits. If exchange is at its highest price, and the im- 
porter must pay $10,060 for a $10,000 bill, $60 is deducted 
from his profit, and the business ceases to be worth while. 

It follows that there is a tendency for an excess of 
either exports or of imports to check itself. If our exports 
increase, other things equal, exchange falls, and this dis- 
courages further exports, but encourages imports. If our 
imports increase too rapidly, exchange rises, and this dis- 
courages further imports and encourages exports. 

The fluctuations of the rate of exchange, then, have a 
tendency to create a balance of exports and imports — allow- 
ance made for other items of international indebtedness, 
Exports and imports, in the long run, must increase or 
decline together. 

put suppose that the margin between prices in two 



292 INTRODUCTORY ECONOMICS 

countries is so wide that it pays to export in spite of a low 
price for exchange, or to import in spite of a high price. In 
the former case, gold must be imported to pay for the ex- 
ports; in the latter gold must be exported to pay for the 
imports. Now, we saw in an earlier chapter that an increase 
in the supply of money tends to raise prices ; a reduction of 
the money supply causes prices to fall. If, then, our prices 
are so low that men find it profitable to send an excess of 
commodities abroad for sale, to be paid for in gold, the con- 
dition must be transitory. For as the gold flows into the 
country, prices rise, and the exporters' gains grow smaller 
and smaller. If on the other hand general prices here are 
so high that it pays importers to bring into the country vast 
amounts of goods, to be paid for by exportation of gold, 
the condition must be equally transitory. With the efflux 
of gold, prices fall, and the profits of importers dwindle 
away. In the end more of our commodities become cheap 
enough to export; and so the balance between exports and 
imports is restored. 

There are men who hold that the United States should 
endeavor to increase its exports, but systematically dis- 
courage importation. It is obvious that such a policy would 
be futile. If our exports increase, our imports will neces- 
sarily increase also, and vice versa. The fluctuations in the 
price of foreign exchange, and the effects of influx or efflux 
of gold, insure this result. Exports and imports are indis- 
solubly united by natural law; governments can destroy 
both, but no policy can be successful which aims to foster 
the one while persecuting the other. 



CHAPTER XIX 
The Regulation of International Trade 

Since early modern times a great part of the energies 
of governments has been expended upon the regulation 
of international trade. The reasons for such regulation 
have been twofold. In the first place, there is a deep-rooted 
belief in the people of every nation that the national pros- 
perity may be furthered by restrictions upon trade with for- 
eigners. In the second place, such trade has long been 
recognized as a convenient and appropriate source of public 
revenue. Most modern regulation of international trade is 
carried on through the mechanism of revenue legislation. 
We shall therefore give to this aspect of the problem our first 
attention. 

Every government needs large funds for the mainte- 
nance of the numerous corps of officials and servants mak- 
ing up its civil and military establishments and for the meet- 
ing of other expenses incurred in the discharge of its vari- 
ous functions. These funds must be obtained chiefly 
through taxation. Two methods of raising taxes are open 
to the government. It may send its officials to each man's 
house, and levy upon his person or property. In this case 
it is said to levy direct taxes. The government may, on the 
other hand, impose taxes upon salable commodities as they 
are found in the hands of producers or dealers. The latter 
then add the tax, in whole or in part, to the selling price 
of the commodities taxed. The buyer of the commodities 
thus bears ultimately all or the greater part of the tax. 
Such taxes are said to be indirect. 

To most of us the tax gatherer is a most unwelcome 
visitor. He inquires politely or otherwise into the extent of 
Qur possessions ; then claps upon us exactions that it may 



294 INTRODUCTORY ECONOMICS 

not be at all convenient to meet. We grumble, but, unless 
we are bad citizens, we recognize that schools must be sup- 
ported, streets must be kept in repair, public order must be 
maintained. For such obvious and imperative public needs 
we are willing to pay taxes. 

But suppose that one of our fellow-citizens, in the hope 
of bettering his private fortunes, betakes himself to a semi- 
barbarous country and builds a railroad. A revolution takes 
place ; the new government confiscates his property. Well, 
we must send a warship, bombard a port, land troops, and 
perhaps engage in a war costing immensely more than the 
railroad is worth. Now, if the tax gatherer came around 
to you and to me, and compelled us to contribute directly 
to the expenses of the affair, we should probably raise the 
question why the man who embarked his fortunes in such 
a venture did not do it at his own risk, not at ours, since 
he left his country for his own profit, not for ours. This 
would of course be reprehensibly unpatriotic; but direct 
taxes are a heavy strain upon patriotism. 

With indirect taxes the case is very different. When- 
ever you buy a pound of imported sugar (and most of our 
sugar is imported) you pay a tax. Whenever you buy 
English woolens or cottons or French silks, you are taxed. 
If you use tobacco in any form, or spirituous, malt or vinous 
liquors, you pay taxes. And so with a host of other com- 
modities. How great is the aggregate yearly sum that you 
contribute to the Government in indirect taxes ? You prob- 
ably have not the least idea. But this is certain ; if the en- 
tire amount were collected from you in cash at one time, 
you would feel that this Government of ours is an expensive 
luxury. Statesmen would find much greater difficulty in 
convincing you that we should have the greatest navy afloat, 
or that we should hold ourselves in readiness to enter upon 
a $2,000,000,000 war over a $200 matter. 

For the ambitious purposes of a central government, 
then, indirect taxes are vastly superior to direct taxes. And 



INTRODUCTORY ECONOMICS ^95 

of indirect taxes, those levied on foreign trade are the most 
convenient. All foreign goods must cross the national 
frontier, where there are always officials and soldiers whose 
services can be employed in preventing goods from being 
secretly carried into the country. A few points through 
which such goods must pass may be designated ; a compara- 
tively small body of officials may be stationed at these 
points, to levy and collect the taxes. The foreign merchant 
may protest against what seem unduly heavy exactions, but 
the protests of foreigners never make a government un- 
popular. If on the other hand we levied a tax on the prod- 
uct of a domestic industry — say sugar — we should meet 
with much greater difficulties. An official would have to 
be stationed at every point where sugar is made, to see that 
the manufacturers did not defraud the revenue. Minute 
regulations of the process of manufacture might be neces- 
sary, to the same end, and these would restrict the liberty 
of the producer and check the progress of the industry. 
Small establishments might have to be discouraged, to avoid 
excessive costs in collecting the revenue, and this would 
mean discrimination against our poorer citizens in favor 
of our richer ones. If the tax were heavy, manufacturers 
would complain that their business was ruined, and this 
would weaken the position of the political party responsible 
for the imposition of the tax. It is, therefore, easy to see 
why we have few indirect taxes on production, and these 
limited to commodities that are regarded as deleterious 
(tobacco, spirituous, malt and vinous liquors), while our 
taxes on imported commodities are innumerable. 

Another reason for the popularity of taxes on imports 
is that many persons believe that such taxes are borne by 
foreigners. If we tax British woolens, French silks and 
German sugar, are we not compelling the British, French 
and Germans to help pay the expenses of conducting our 
Government? Only in minor degree, if at all. Let us 
say that a given grade of woolen goods is produced in Eng- 



296 INTRODUCTORY ECONOMICS 

land at a cost of fifty cents a yard. Under the laws of com- 
petitive industry, the cloth sells in England for very nearly 
fifty cents. If the cost of bringing it to this country is one 
cent a yard, and there is no tax on imports to pay, the cloth 
will sell here for about fifty-one cents. Now if we place a 
duty of fifty cents a yard on the cloth, none of it will be 
sold here for less than the British price plus the cost of 
transportation plus the tax, or a dollar and one cent. The 
man who buys the goods for use pays the tax, in the last 
instance. And so with most import duties. There are ex- 
ceptional cases in which the whole amount of the duty can- 
not be added to the original price of imported goods. In 
these cases the foreign producer may be said to bear part of 
the tax. As a general rule, however, the consumer of the 
goods pays the tax, although he may not be conscious of 
the fact. 

Taxes on foreign trade may be levied upon either im- 
ports or exports or upon both. Export taxes are generally 
unpopular, because of the common belief that it is a good 
thing to export as many goods as possible. In the United 
States export taxes are prohibited by the Constitution. We 
shall therefore confine our study to taxes on imports. 

Taxes on imports may be levied either for the purpose 
of obtaining a revenue or for the purpose of discouraging 
importation. Before the annexation of Porto Rico all the 
coffee used in the United States came from foreign soil. A 
tax (or ''duty") of, say, five cents a pound under the con- 
ditions would have discouraged importation in only a slight 
degree. Most of us would have used as much coffee, even 
at the higher price. A duty of $20 a ton on steel, on the 
other hand, would practically prohibit the importation of 
steel. For our own steel industry can produce steel almost 
as cheaply as that of any foreign country. Suppose that 
we can produce steel at $15 a ton while in some foreign 
country it can be produced at $12. If the cost of bringing 
steel from the foreign country is $2 a ton, foreign producers 



INTRODUCTORY ECONOMICS 297 

can sell steel here at lower prices than our own producers 
can afford to take. But if foreign steel is compelled to pay 
a duty of $20 a ton, none of it can be sold here, unless the 
American producers combine and force steel up to the price 
of $34 a ton. Such a duty, since it "protects" domestic pro- 
ducers against foreign competition, is known as a protective 
duty. 

All duties levied upon imported goods of a character 
that cannot be produced in a country may be classed to- 
gether as pure revenue duties. All duties levied on goods 
of a character that can be produced in a country are protec- 
tive duties. Of course a duty the aim of which is the rais- 
ing of revenue may be incidentally protective. Thus if we 
were to levy a duty on imported coffee, it would "protect" 
the coffee growers of Porto Rico. On the other hand, pro- 
tective duties may incidentally yield a revenue. In the case 
employed above, if the duty on foreign steel had been $1 
instead of $20, foreign steel would have continued to be 
imported, and thus a revenue would have been obtained. 
At the same time the foreigner would have been prevented 
from underselling the American; accordingly, the latter 
would have been "protected." Most of our duties are pro- 
tective, but incidentally yield a revenue, as they are not high 
enough to prevent importation altogether. 

The schedule of all duties levied by a country is known 
as the "tariff." A tariff consisting of duties whose main 
object is the raising of a revenue is known as a revenue 
tariff. Such a tariff has long been in force in England. A 
protective tariff consists mainly of duties whose purpose is 
the protection of domestic producers against foreign com- 
petition. Such a tariff has been in force in the United States 
since early in the nineteenth century ; its character has been 
most strongly marked since the Civil War. 

A revenue tariff needs no defense. A state must have 
revenues, and there is no easier way of collecting them than 
through import duties on commodities that we cannot our- 



298 INTRODUCTORY ECONOMICS 

selves produce. A protective tariff, on the other hand, re- 
quires more extended consideration. It is designed to foster 
domestic industry at the expense of the business of impor- 
tation. Whether it does this or not is a question of great 
importance. We must see exactly how such a tariff affects, 
not merely isolated branches of industry, but the industry 
of a nation as a whole. 

There is a very primitive view, unfortunately yet far 
from extinction, that it is an evil thing to buy anything from 
foreign producers — even the things that cannot be produced 
in the country at all. Those who hold to this view imagine 
that we must send abroad money to pay for all purchases, 
and money, they say, should be kept at home. We saw in 
the last chapter that the medium through which international 
payments are effected is, in a vast majority of cases, bills of 
exchange. The shipping of gold from country to country 
is reduced, by the mechanism of exchange, to very small 
proportions. Now, the bills of exchange with which we pay 
for our imports are really due bills, representing the value 
of commodities that we export. We saw also that if a coun- 
try for a time imports more than its exports will pay for, 
bills on foreign points rise in price, and this discourages 
further importation and encourages further exportation, 
until the proper balance between imports and exports is 
again restored. Accordingly, we may cheerfully proceed 
to import as large a volume of commodities as we may desire. 
We shall not thereby run the risk of a serious drain upon 
our money supply; we shall merely make preparations for 
an unusually large and profitable export trade in the near 
future. 

Some men who have advanced beyond the view that 
all importation of commodities is an evil yet cling to the 
belief that importation from countries that do not buy as 
much from us as we buy from them is to be discouraged. 
They argue that such trade must leave a balance which we 
must pay in gold, and this they regard as a net loss. Not 



INTRODUCTORY ECONOMICS 299 

many years ago one of the administrative departments at 
Washington published a report containing the statement 
that our losses from trade with South America, during the 
last half century, exceeded the cost of the Civil War. For 
we had purchased from those countries billions of dollars* 
worth of commodities in excess of their purchases from us. 
Of course, the facts in the case are not that we have sent 
billions of dollars in gold to South America, but that we 
have paid the balance in bills on England. England buys 
more from us than she sells to us, and in her turn, sells more 
to South America than she buys from that region. If ever 
the import trade with South America assumes abnormally 
large proportions, the export trade with England expands 
in sympathy. It makes not the slightest difference whether 
our foreign trade is three-cornered, as in this case, or 
whether it is carried on directly with one other country. 

Slightly less shallow is the view that one should not 
buy from foreigners commodities that he can obtain from 
his fellow-citizens, even if the latter demand higher prices 
than foreigners are content to receive. If you wish to buy 
an automobile, it is urged, you should buy one of American 
make, even if you can get as good a one of French make a 
little cheaper. By so doing you will increase the prosperity 
of the American automobile industry. You will enable the 
industry to employ more men at higher wages, and to pay 
higher dividends to those who have invested their capital 
in the industry. That you and the rest of your class may 
be sure to lend your aid to the American industry, the Gov- 
ernment should place a tax on French automobiles imported 
into the country, which, added to the original price, will 
make them sell at higher prices than those made in this 
country. If you then persist in encouraging French industry 
instead of that of your own country you will have to pay 
dearly for the privilege. 

The ulterior effects of a policy that compels American 
buyers to patronize the home industry are no less happy (so 



300 INTRODUCTORY ECONOMICS 

runs the familiar argument). The laborers and capitalists, 
being more prosperous, have more to spend on products for 
their own use. The capitalists erect mansions and the 
laborers build cottages, and this creates employment for car- 
penters, masons and other craftsmen in allied trades. These 
in turn have more money to spend, and increase their pur- 
chases of clothes, provisions and other articles of use. And 
so the beneficent effects of confining one's purchases of auto- 
mobiles to the American industry are widely distributed 
throughout society. 

In a similar way it is urged that we should buy all our 
sugar from our own producers. There is not much doubt 
that in ten years we could extend our production of sugar 
sufficiently to cover the demand for it, if we would but pay 
a sufficiently high price to tempt labor and capital into the 
industry. Instead of sending $100,000,000 abroad to fruc- 
tify foreign industry, we could keep it at home among our 
own workingmen and capitalists. 

Let us see whether the foregoing argument will bear 
close examination. Assuming that we import $100,000,000 
of sugar in a year, how do we pay for it? Not with gold, 
but with bills of exchange representing the value of com- 
modities that we export. 

Now suppose that we place so high a duty on sugar 
that importation ceases altogether. The immediate effect 
would be a reduction in the demand for foreign bills aggre- 
gating $100,000,000 per annum. Bills would, of course, 
fall below par; men exporting wheat and meat and cotton 
would get less for their products in consequence. The im- 
portation of commodities other than sugar would be stimu- 
lated, as we have seen, by the low price of bills. Exports 
and imports would have to be brought to a balance again, 
and this would come to pass through a shrinkage of exports 
and an increase of imports other than sugar. Perhaps we 
would buy annually $50,000,000 more of these other im- 
ports than we did before, and export $50,000,000 less of 



INTRODUCTORY ECONOMICS 3OI 

wheat, meat and cotton than we formerly exported. The 
producers of sugar are indeed benefited by the elimination 
of foreign competition, but the producers of wheat, cotton, 
etc., are injured by the reduced prices of exports, and the 
producers of other commodities, part of the supply of which 
is imported, are injured by the increase in importation of 
those commodities. Obviously enough, the evil ulterior 
effects of the losses of these two classes of producers cancel 
the beneficent ulterior effects of the gains of the sugar pro- 
ducers. The one effect of the duty that stands out with- 
out any corresponding offset is that we shall pay ten cents 
a pound for sugar instead of five — certainly a result that no 
one can ardently desire. 

But suppose that the Government places prohibitive 
duties on all imports. Will not this place all industries in a 
position where they may enjoy higher prices? And in that 
case, will it not be as easy for us all to pay ten cents a pound 
for sugar as it now is to pay five? A protective system, it 
is often said, is unjust when it singles out a few industries 
and grants them special favors. But it is just if it favors 
all industries equally. 

An obvious objection is that if this were possible, if 
each industry were enabled to charge prices one hundred per 
cent, higher and each person, accordingly, received twice as 
large an income as he would otherwise have received, no 
one would secure any real benefit at all. If the income of 
each of us should be doubled, and we had to pay twice as 
much for everything that we buy, none of us would be any 
better off than we are now. But a more serious objection is 
this : no protective policy can raise the prices of all com- 
modities. A duty can affect the prices only of articles that 
we are in the habit of importing. Now, if we import any- 
thing, we must export something to pay for it, and the 
export commodities must ordinarily represent as great a 
volume of value as the import commodities. In the case 
of the United States, the volume of export commodities 



302 INTRODUCTORY ECONOMICS 

must be greater than that of the import commodities, for the 
former must pay interest on capital that we have borrowed 
and the cost of transporting our trade in foreign ships. 

Now, the price of a commodity that we export must be 
lower in this country than in the countries to which it is 
sent. The prices of wheat and cotton in America must be 
less than the prices of the same articles in England, since 
we are constantly exporting them. It is manifestly absurd 
to suppose that by placing duties on wheat and cotton im- 
ported into the United States we can raise the price of those 
commodities. Who will wish to import them into the 
United States? The duty on any export product is utterly 
ineffective. 

We have seen that restrictions on imports restrict ex- 
ports also. They do this by reducing the amount of money 
that the producer for export receives for his goods. An 
*'all around" system of duties, in spite of itself, imposes a 
positive burden on as large a volume of industry as that 
which enjoys special favors under it. 

Another argument for protective duties runs as fol- 
lows: The American laborer requires a greater measure 
of the necessaries and comforts of life than the laborers 
of any other country. His wages must therefore be higher. 
It follows that American enterprisers, having higher wages 
to pay, are at a disadvantage as compared with their foreign 
competitors. They must therefore sell their goods at higher 
prices; and this they would be unable to do if the foreign 
producer could bring his goods here without payment of 
duty. From this point of view the tariff is regarded as the 
bulwark of the American standard of living. 

This argument can no more bear analysis than the pre- 
ceding ones. All the export industries are able to pay the 
American scale of wages, and yet undersell their foreign 
competitors on foreign soil. These industries are hampered, 
not aided, by the protective system. Apart from the injury 
inflicted upon them by an unfavorable rate of exchange. 



INTRODUCTORY ECONOMICS 303 

these industries are rendered less profitable by the fact that 
many of their expenses are increased by the tariff. Wheat 
and cotton growers are compelled to pay higher prices for 
agricultural implements, lumber, fertilizers and other sup- 
plies because of the protective duties. The duties on iron 
and steel increase the costs of railway building and are re- 
flected in higher freight rates, which represent a deduction 
from the net gains of the producers of the commodities that 
are carried to the ports by rail. If restrictions on imports 
reduce the amount of freight carried to this country from 
Europe, many ships will be compelled to cross the ocean in 
ballast to carry away our exports ; and this means that the 
exports will have to pay ocean freights covering the costs 
of a return voyage, instead of a single passage of the ocean. 
Now, when we consider that in spite of all these disadvan- 
tages the export industries can retain the home market and 
invade foreign ones, we see clearly that a protective tariff 
is not needed to maintain the American rate of pay in all 
industry, although it may be necessary to maintain that rate 
in special industries — industries in which our advantages 
for production are less telling than they are in those in- 
dustries that have succeeded in conquering a place for them- 
selves in foreign markets. 

In order to obtain a clear view of the relation of a 
protective duty to the rate of wages we must return to fun- 
damental principles. In any country, as was shown in earlier 
chapters, wages are determined by the marginal produc- 
tivity of labor. We will represent the various opportuni- 
ties for employment that a country like the United States 
affords by the symbols A, B, C and D. A may stand for a 
group of industries in which we have exceptional advan- 
tages over foreign countries. B stands for a group of indus- 
tries in which our advantages are less, C one in which they 
are still less, and D the group of industries in which they are 
least of all. When our population is so small that all our 
labor can be engaged in the group represented by A, wages 



304 INTRODUCTORY ECONOMICS 

will be at their maximum. When our population increases 
so that some of the labor will have to be set at work in group 
B, the wages of all labor must decline to the level of produc- 
tivity in that group. We will suppose that population has 
increased up to a point where the opportunities represented 
by A and B are fairly well manned, and wages are deter- 
mined by the productivity of labor in B. 

With wages thus determined, it is clear that no em- 
ployer, without governmental aid, can afford to hire labor 
to exploit the opportunities represented by C and D. This 
would necessitate paying labor in C and D as much as it pro- 
duces in B, and that, by hypothesis, is more than it produces 
in C and D. 

Now let us suppose that a political party is in power 
which holds the belief that we should produce everything 
that we consume— that is, that the opportunities represented 
by C and D should be exploited as well as those represented 
by A and B. Labor must be drawn away from A and B and 
set at work in C and D. This involves the necessity of 
compensating enterprisers in some way for the disadvan- 
tages under which they will labor in C and D. Either wages 
must be reduced in A and B, or some form of subsidy must 
be granted to C and D. 

The commodities that the industries composing C and D 
will produce have been hitherto, we assume, obtained from 
abroad through exchange for commodities produced by A 
and B. The Government now renders this difficult by plac- 
ing high duties on the former class of commodities. This 
means that producers in the groups A and B — both em- 
ployers and workmen — must pay higher prices for what they 
buy. They do not receive higher prices for what they sell ; 
in fact, they receive lower prices, as this, we have seen, is 
the effect of protective duties on export industries. It 
appears, then, that part of the disadvantage of producers in 
C and D is removed by reducing wages (estimated in pur- 
chasing power) in A and B. 



INTRODUCTORY ECONOMICS 305 

After the duty has gone into effect and the prices of 
commodities that can be produced by C and D have risen 
sufficiently, enterprisers will be able to hire labor at the wages 
prevailing in A and B, and establish industries in C and D. 
So far as the remaining laborers in A and B buy the products 
of C and D, the difference between the price which they pay 
for those products and the price that they would pay if they 
were permitted to import those products duty-free is a tax 
paid not to the Government, but to the producers in C and 
D, to enable the latter to remain in business. It is an un- 
compensated deduction from the natural earnings of the 
laborers in A and B. Their wages have been reduced ; nor 
are the workers in C and D paid as much, estimated in 
purchasing power, as they would have received if they had 
been allowed to remain in A and B under the earlier condi- 
tions. The net effect of the imposition of the duty has been 
to saddle the self-supporting industries, A and B, with the 
support of the pauper industries, C and D. Yet the inventors 
of this policy will have the effrontery to tell laborers in A 
and B that this policy is the bulwark of their high rate of 
wages 1 

The principles involved in the illustration may be stated 
in the following general terms : Wages in America will be 
at their highest point when all our labor is concentrated in 
the industries in which our relative advantages over other 
countries are greatest. If there are no protective duties 
whatsoever, employers will, as a rule, seek out the industries 
in which we have the greatest relative advantages. Pro- 
tective duties enable other industries to exist, but only 
through taxing the more productive industries for their 
support. Protection as a permanent policy means a slight 
reduction of money wages, and a greater reduction of wages 
estimated in purchasing power. Instead of a bulwark of 
the American standard of living, protection is a serious 
menace to it. 

The arguments for protection that have been discussed 



306 ' INTRODUCTORY ECONOMICS 

are all manifestly fallacious. They are not therefore to be 
despised, since to hosts of men they appear to be absolutely 
irrefutable. And this, as a great French economist was 
wont to say, is because the average man is unable to weigh 
the unseen effects of an economic policy against the effects 
that are seen. If we place a high duty on imported fabrics, 
the resultant high prices enable a new industry, employing 
thousands of workmen, to be established. This is the effect 
that is seen, and considered in itself, is wholly good. Every 
purchaser of the fabrics throughout the land is compelled to 
pay higher prices for them; but this effect is only dimly 
seen, if at all. In itself, it is wholly evil. Since part of 
what the new industry receives in this way from the public 
goes to compensate that industry for the natural disad- 
vantages under which it labors, it follows that the aggregate 
net gain to the industry is less than the aggregate net loss 
to the public. Again, the national production of wealth is 
increased by the amount that the new industry adds, and this 
effect of the duty is one that is seen. The national production 
is reduced by the amount that the labor and capital diverted 
to the new Industry would have produced elsewhere; but 
this effect is not seen. Yet the reduction in national produc- 
tion that the duty entails is greater than the increase due to 
it, since labor and capital are diverted from the branches of 
production enjoying greater natural advantages to branches 
enjoying lesser advantages — a fact proved by the very need 
for a duty. 

In the foregoing discussion the assumption has been 
made that when left to themselves enterprisers will seek 
out the industries enjoying the greatest natural advantages. 
On this assumption, all that government can do is to force 
industry into the less productive fields — a policy that can 
result only in reducing the national production. 

Now, while the assumption is ordinarily defensible, it is 
not universally valid. Enterprisers do not always know 
what fields offer the highest rewards. Furthermore, eyen if 



INTRODUCTORY ECONOMICS 307 

an enterpriser suspects that a given field, hitherto unex- 
ploited, would offer rich returns, conservatism may deter him 
from abandoning a field in which he is already gaining profits 
for a field in which he may gain larger profits, but in which 
he may also incur losses. 

The men who govern a nation may be more far-sighted 
and more progressive than the business men of the same 
nation. The former class of men may become convinced that 
certain fields of production will be profitable long before the 
latter class will venture into those fields. The government, 
by placing duties upon the products that those fields might 
yield, makes success a certainty. Once the new industries 
are established, the duties might be removed without de- 
stroying them. The industry of the nation is enriched by 
the addition of fields of employment that are as good or 
better than those already under exploitation. 

It must, of course, be borne in mind that this case is 
a rare one. It is not often that the statesman knows more 
about business than the body of business men themselves. 
Where, however, the government is manned by officials of 
a race intellectually superior to that of the governed, the 
national industry might be furthered in the way de- 
scribed. 

Even when there exists no superiority of foresight on 
the part of those who make up the government, a govern- 
ment may often succeed in diverting industry from fields in 
which the natural advantages are less to fields in which 
they are greater. The United States has always possessed 
special natural advantages for the production of iron and 
steel. What it lacked, in its early period, was training in 
the art of working metals. The enterpriser was unac- 
quainted with the best processes, and he had to use labor that 
had not acquired the skill and the traditions necessary for 
efficient production. 

Now, the only way to acquire an art is to practice it. 
We had to make iron for a long time before we could become 



308 INTRODUCTORY ECONOMICS 

adepts in the art. A generation might have sufficed for 
estabHshing the industry in a particular locality ; but what 
enterpriser would have undertaken to produce at a loss 
through a generation in order that some other enterpriser 
might ultimately conduct the business with a profit? Obvi- 
ously, the case demanded governmental aid. And the 
Government did indeed come to the aid of the industry, 
through the imposition of duties on imported iron and 
iron wares. 

A generation may suffice to establish the industry in a 
given locality, but if the production of iron in other locali- 
ties promises ultimate success, the duties must be continued 
for the benefit of these localities. At a time when the first 
center of the industry is in a position to bid defiance to 
foreign competition, other centers are still in extreme need of 
protection. 

To-day our iron and steel industries are highly devel- 
oped. There is excellent reason for believing that in many 
sections of the country these industries could get on very 
well without the protection they continue to receive. In other 
parts of the country the industry may still be in need of 
protection. Now, is it expedient to continue protection as 
long as any part of the industry needs it? To do so is to 
enable those parts that are already able to stand without aid 
to levy upon the rest of the industry of the country. 

After an industry has been well established within a 
couhtry, it migrates without great difficulty to other parts of 
the same country, if natural conditions warrant. If the iron 
industry has been established in Pennsylvania, it will readily 
migrate to Alabama or Colorado, if natural conditions are 
as good or better than they are in Pennsylvania. Processes 
that are in use in Pennsylvania can be transferred without 
cost to the other regions ; a body of workers can be induced, 
without great difficulty, to migrate v/ith the industry. There 
is accordingly far less reason for giving governmental aid 
to the newer centers than there was for giving it to the 



INTRODUCTORY ECONOMICS 309 

original one. Accordingly, we may say that it may be ad-' 
vantageous to protect an industry until it is well established 
within the national domain ; if it is of a character that fits 
it for existence there, it will extend itself to other regions 
even if protection is withdrawn. 

When an industry has become firmly established, fur- 
ther protection is inexpedient and unjust, as it enables the 
industry to collect from other industries that are self-sup- 
porting a tribute that it does not need. Here a practical 
difficulty arises. How can we determine just when an indus- 
try has passed through the period of infancy, and therefore 
should be left to shift for itself ? We cannot find out from 
those who are engaged in the industry, since they are natur- 
ally desirous of a continuance of public aid, even though 
they do not need it. And those who are not engaged in the 
industry cannot tell. 

At the annual banquets of the various manufacturers' 
associations, the boast is frequently made that we can manu- 
facture more cheaply than any other nation on earth. But 
if Congress proposes to reduce duties, the same men soberly 
declare that our industries will be ruined if this is done. 
And shall Congress, in its search for truth to enlighten it, 
appeal from the manufacturers sober to the manufacturers 
off their guard and intoxicated with success? The fact is, 
it is almost impossible for a government to determine just 
when a protective duty can be removed. As a result every 
nation retains many such duties long after they have lost all 
efficacy for doing anything but harm. Accordingly, there is 
good reason for the view that reckless experimentation in 
the establishment of new industries is to be avoided. 

A stronger reason for cautious action lies in the fact 
that an industry established by the aid of a protective duty 
may never develop sufficiently to maintain itself without 
governmental aid. The natural conditions upon which it is 
based may be so unfavorable, relatively to the conditions 
in other countries, that the industry, if established here, will 



3IO INTRODUCTORY ECONOMICS 

be destined to remain forever a burden upon the public — a 
pauper industry. Let us suppose that in a given branch of 
industry a commodity can be produced here at a cost of 
$1, while it can be obtained from abroad for fifty cents. 
Without government aid, no enterpriser can afiford to under- 
take its production. Now, let us assume that a statesman, 
anxious to see the United States producing every possible 
kind of goods, succeeds in placing a duty of fifty cents on the 
imported article. The price to consumers must then rise to 
$1, a price sufficient to induce American enterprisers to pro- 
duce the goods. 

After all the initial difficulties, such as training a force 
of men, establishing market conditions, etc., have been over- 
come, the cost of producing the article may fall to seventy- 
five cents, and remain there. This is the natural American 
cost of it. If the duty is removed, the foreign article will 
again be sold for fifty cents. The men who have put their 
capitals into the industry will have to close down their plants 
and discharge their workmen. The buildings and machinery 
used in the industry will probably be worth almost nothing 
for any other purpose. The skill acquired by the workmen, 
at great cost of time, perhaps, will be equally worthless. 
The removal of the duty, therefore, involves the ruthless 
destruction of means of wealth production, through no fault 
of the possessors of such means. 

The question naturally arises, is it right to call an in- 
dustry into existence by governmental action, and later aban- 
don it to the mercies of foreign competition? There can be 
but one answer: It is not right. The government did 
wrong in calling into existence an industry that would never 
be able to survive unaided. It does wrong again when it 
abandons its ill-begotten offspring to die of starvation. If, 
however, the industry is not abandoned, it is a perpetual ex- 
pense to the self-supporting industries of the country. A 
human pauper dies in the end, but a pauper industry ma^ 
live on forever, 



INTRODUCTORY ECONOMICS 3II 

A protective tariff may sometimes be defended on the 
ground that it preserves the natural resources of a country 
against wasteful exploitation. If the Government does not 
restrict international trade, we may, as a rule, assume that 
enterprisers will seek out the fields in which a given quan- 
tity of labor and capital will produce the largest amount of 
value, or the fields in which our advantages over foreign 
countries are greatest. Let us suppose that one of those 
fields is the growing of wheat. In most parts of the United 
States wheat culture represents a heavy drain upon the fer- 
tility of the soil. Land devoted to constant wheat cropping 
becomes almost exhausted in a generation. Accordingly, 
when one sells a bushel of wheat, he sells not only the prod- 
uct of his labor and capital, but a part of the natural heritage 
of his country. But why should he care? After his field 
is worn out, his years will probably be few. The next gen- 
eration may be left to repair the wastes of this generation. 

Let us suppose that coal and iron mining and the pro- 
duction of petroleum are other industries in which we have 
great natural advantages. Enterprisers, if left to themselves, 
would employ vast amounts of labor and capital in exploit- 
ing these natural resources. Every year we should send 
away from our country these commodities, representing not 
merely the annual product of our labor and capital, but also 
a part of our irreplaceable natural wealth. In a few genera- 
tions we should be, as a nation, impoverished. 

We have seen that protection places a burden upon the 
industries in which we have, for the present, great natural 
advantages. In order to build up industries in which our 
natural advantages are less. If the industries that are natur- 
ally most productive are of the kind that waste the natural 
wealth of the country, it is a statesman's proper policy to im- 
pose upon them such burdens, and so reduce the extent to 
which they are carried on, in favor of industries which in- 
volve no waste of resources, even though the annual produc- 
tion of wealth is thereby diminished for a time. 



312 INTRODUCTORY ECONOMICS 

The same argument, of course, condemns protection 
under other circumstances. According to conservative offi- 
cial estimates, we are using up, each year, four times as 
much lumber as we are growing. The rising price of lumber 
stimulates the activity of the woodsman to greater and 
greater remorselessness. Our mountains are denuded, and 
the waters, formerly held back by the forest covering and 
allowed to feed the rivers with regular flow, now sweep 
down the slopes in devastating flood. Obviously, we should 
endeavor to stimulate importation of lumber ; if necessary, 
we should give a bounty on imports, that the price of lumber 
might be reduced and our few remaining forests saved. But 
the destroyers of our natural heritage demand protection in 
their pernicious pursuit, and we accord it to them. 

If extractive industries, prosecuted too relentlessly, 
waste the natural wealth of a country, manufacturing indus- 
tries, prosecuted in the same way, waste its men. The popu- 
lation of a manufacturing center does not compare at all 
favorably, in health and vigor, with the population of rural 
districts. Indeed, it is doubtful whether an exclusively urban, 
manufacturing population can in the long run escape phy- 
sical degeneration. It might therefore be good policy in a 
country so largely devoted to manufactures as England to 
impose protective duties on imported agricultural products, 
with a view to increasing the proportion of the population em- 
ployed upon the land. This would indeed burden the manu- 
facturing population; it would for many years reduce the 
product of the national industry. But in view of the ulti- 
mate effect upon the character of the population, this policy 
might be a good one from the point of view of the statesman, 
who must consider not merely the prosperity of this year 
and next, but also that of the remotest generations. 

There are industries that in the end destroy the health 
of those who are engaged in them. A frequently cited case 
is a certain branch of the match industry, which condemns 
its workers to early disability or death. Yet in many coun- 



INTRODUCTORY ECONOMICS 313 

tries that industry asks for protection and gets it. Protec- 
tion and encouragement to an industry that literally devours 
one's fellow-countrymen ! 

A protective duty is defensible when it serves to main- 
tain facilities for the production of articles of national neces- 
sity, the supply of which might be cut off by war. War 
vessels can be built in Great Britain at far less cost than in 
the United States. In time of peace we should make im- 
portant savings by having our war vessels built in Great 
Britain. If we were engaged in a war, however, we could not 
have warships built in Great Britain, whether that country 
were hostile or neutral. Yet it is precisely at such a time that 
we should most need to increase our navy. Prudence there- 
fore demands that we should provide ourselves, in time of 
peace, with establishments capable of turning out warships^ 
and this involves giving them work to do. 

It is a moot question whether the creation of facilities 
for constructing merchant ships stands on the same foot- 
ing. In former times, certainly, a merchant fleet was an 
indispensable auxiliary to a fighting fleet. The former fur- 
nished trained seamen, and many merchant vessels were 
capable of speedy transformation into warships. Modern 
methods of construction, however, have widely differentiated 
between merchant ships and ships of war. The former can- 
not be fitted out in such a way as to enable them to perform 
eflicient service in line of battle. The crews of merchant 
ships are not such satisfactory material for a naval force as 
was formerly the case. Whether the national defense re- 
quires the development of a sea-going merchant fleet or not 
is a question for disinterested experts to determine. If it 
does, protection to the American merchant marine is defens- 
ible, despite the cost that it inevitably entails. 

Many industries that are not designed directly for the 
supply of articles of military necessity may be placed in the 
same class. In order that we may be able to construct ships 
and produce guns and other instruments of v/ar, we must 



314 INTRODUCTORY ECONOMICS 

have men who are trained in metal working ; and if there is 
no other way of maintaining such a force of workmen, we 
should create and maintain an iron and steel industry- 
through protective duties. It is, however, to be borne in 
mind that the maintenance of an industry large enough to 
cover all the demand for iron and steel in time of peace can- 
not be urged on grounds of national defense. 

There are some writers who extend the principle in- 
volved to an unwarranted extreme. They would have every 
nation produce practically every article that it consumes, in 
order that in time of war there might not be the least inter- 
ruption of supplies. These persons exaggerate the de- 
pendence of one country upon any other country against 
which it may at some time wage war. England, every one 
knows, does not produce enough grain to feed her popula- 
tion. Suppose that England found herself at war with the 
United States. That would indeed cut off American sup- 
plies of wheat and meat and cotton. But there are many 
other countries that would be glad to provision England at 
the rates she can afford to pay ; and as for cotton, the Eng- 
lish buyers would not be a whit worse off than the American 
sellers, cut off from their natural market. 

But suppose that a coalition of all the powers succeeded 
in destroying the British fleet, and in cutting off supplies 
from every source. Would not Great Britain be brought 
face to face with famine ? Certainly. But a coalition strong 
enough to do this would be strong enough to invade and sub- 
jugate Great Britain, even if that country were absolutely 
self-sufficing. Furthermore, any one who knows anything 
of the history of coalitions knows that none will ever be 
formed for the purpose of bringing the British nation to ex- 
tinction. 

The strength of a nation in time of war does not de- 
pend upon its ability to produce everything that its inhabi- 
tants consume. Rather, it depends upon the valor and num- 
ber of its men, and upon its general wealth. Other things 



INTRODUCTORY ECONOMICS 315 

equal, a rich nation will overcome a poor one in war. Great 
Britain is formidable because she is rich. Now, the endeavor 
to make a nation absolutely self-sufficing would end in mak- 
ing it much poorer than it would be if it used its resources 
in a more economical way. If we were to endeavor to raise 
coffee and tea, lest an impossible coalition of all the world 
might inflict upon us the hardships of dry breakfasts, we 
should waste so much of our energies in the attempt that we 
should be weakened in the event of an ordinary war, in 
which we may any day become involved. 

One further possible justification of protective duties 
requires examination. Other countries impose duties upon 
American products crossing their borders. Therefore, it is 
said, we should impose import duties on the products of such 
countries, by way of retaliation. Let us see whether this 
position is tenable. 

If Germany places a high duty on American meats, the 
persons who are injured most seriously are the German 
consumers of meat. The German producer of meat gains an 
advantage, but this, under ordinary circumstances, is not 
commensurate with the loss to the German consumer. The 
world demand for American meat is somewhat reduced, and 
this reduces the price of it slightly. A small injury, there- 
fore, is inflicted upon the American producer of meat. 

Now let us suppose that in retaliation we levy extraor- 
dinary duties on German sugar. The chief sufferer will be 
the American consumer of sugar. The American producer 
will gain, but not commensurately. The world demand for 
German sugar will be reduced, and this will slightly reduce 
the price of it. Thus, in order to punish Germany for in- 
flicting a large loss on German consumers and a small one 
on American producers, we inflict a large loss on American 
consumers and a small one on German producers. 

But retaliation is war, and in war the petty rules of 
logical conduct are not to be observed. The important ques- 
tion is this: does the policy of retaliation effect its pur- 



3l6 INTRODUCTORY ECONOMICS 

pose? Will we compel Germany to remove the obnoxious 
duty? In all probability, no. After the duty on meat has 
been in force for some time, German producers will increase 
their facilities for producing that article. To remove the 
duty and expose to the mercies of foreign competition the 
men who had invested their capitals in good faith would be a 
policy as unjust as it would be unpopular. Similarly, Ameri- 
can enterprisers would extend their facilities for producing 
sugar, and this would give them an equitable claim to a con- 
tinuance of the duty. The only result of retaliation is the 
institution of permanent protection. If permanent protection 
is desirable, it should be undertaken without reference to the 
way in which a foreign government conducts its own affairs. 
If it is undesirable, it should not be undertaken at all. 

In conclusion we may say that protective duties may be 
defensible (i) when they make possible the introduction of 
an industry which in a reasonable time will compare favor- 
ably in productivity with industries that are already self-sup- 
porting; (2) when they preserve the natural resources of a 
country from wasteful exploitation; (3) when they 
preserve the vigor and progressiveness of the population 
through the maintenance of a just balance between manu- 
facturing and agriculture, city and country ; and (4) when 
they make possible the maintenance of industries that add 
materially to a country's strength in time of war. In any 
case such duties are a burden upon the national wealth, at the 
time when they are instituted, and often for an indefinite 
time thereafter, and whether the benefit to be gained is a due 
compensation for the burdens involved is a question demand- 
ing in each case careful consideration. Duties that are de- 
signed to raise wages or to increase the national wealth by 
the introduction of industries in the prosecution of which we 
have no special advantages, are founded in a delusion. They 
are rendered possible only by the fact that the ordinary mind 
does not weigh their unseen disadvantages against their ad- 
vantages patent to view. 



CHAPTER XX 
The Economic Relations of Government 

The economic world with the study of which we have 
been engaged is a world of free private enterprise. Its 
motive forces are the acts of individuals, each seeking to 
further his own material interests. When such buy or sell 
material possessions or personal services, they take little 
thought of the interests of society as a whole, and are little 
concerned with the wishes or the will of society. Yet the 
will of society plays a part in all these transactions, for they 
are shaped with tacit reference to the law. The individual 
is free to pursue his own interests only within the limits set 
by the positive law of the land. 

If we attempt to contrast the present economic state 
with the state that would probably exist were there no polit- 
ical organization of society, we shall realize that the will 
of society, as expressed in the acts of government (employ- 
ing the term in its broadest sense), has played an exceed- 
ingly important part in economic evolution. Without a gov- 
ernment strong enough to assure to each man the permanent 
possession of material goods acquired in ways recognized as 
legitimate, humanity could hardly have developed beyond 
the hunting, or at any rate the pastoral, stage. Without a 
government able to enforce contracts for the future delivery 
of goods and services, humanity could not have passed be- 
yond the stage in which the small artisan produced goods, 
on his own account, for a narrow local market. Progress 
in the art of government has been a necessary condition 
of substantial economic progress. On the other hand, it was 
in large measure progress in economic life that necessitated 
progress in government. Some of the most serious practical 
problems of to-day have their origin in the fact that political 



3l8 INTRODUCTORY ECONOMICS 

evolution has not kept pace with economic. Our political 
machinery, which developed under simpler economic condi- 
tions, is incapable of maintaining justice under the com- 
plex conditions of the present time. 

A government may limit its economic activities to the 
defense of private property and the maintenance of the 
obligation of contracts. It may assume the function of 
determining the conditions under which economic transac- 
tions are carried on, and may even interfere in their terms. 
It may engage directly in the production of goods and ser- 
vices. In the first case the government is said to pursue a 
"let alone" or laisser-faire policy; in the second case, a 
regulative or "paternalistic" policy ; in the third, a socialistic 
policy. In general, the basis of modern economic policy is 
laisser-faire. True, the regulation of an industry by govern- 
ment is a not infrequent phenomenon, and the direct par- 
ticipation by government in the production of commodities 
and services is not by any means unknown. Nevertheless an 
overwhelming majority of modern economic transactions 
are carried on by private individuals, subject to no direct 
interference on the part of the government. 

The question may arise whether the existence of protec- 
tive tariffs in most of the countries of the world does not 
make it necessary to qualify the statement that laisser-faire 
is the basis of modern economic policy. In effect, the 
United States Government prevents us from buying English 
steel, and compels us to buy steel of American manufacture. 
Yet the method by which it does this does not resemble the 
method of governmental regulation, to be discussed below. 
The Government imposes the condition that every ton of 
steel crossing our borders shall pay a certain tax. This 
condition met, the steel becomes an article to be dealt in 
freely. In buying or selling it men consult only their own 
self-interest. The imposition of the duty creates a steel 
industry in this country; but the method by which this is 
done is very different from the method of governmental 



INTRODUCTORY ECONOMICS 319 

production. Prices are enhanced ; and this leads individuals, 
in the pursuit of their private interests, to engage in steel 
production. The Government, as it were, creates a favor- 
able soil in which free enterprise may flourish. We may, 
therefore, say that the existence of customs barriers does 
not render necessary a qualification of the statement that the 
economic policy of modern governments is based upon the 
principle of laisser-faire, or free enterprise. 

The system of free enterprise has been at once the 
subject of extravagant praise and of savage criticism. Some 
writers attribute to it all the progress in civilization that 
the last centuries have witnessed. To these writers every 
encroachment by government upon the domain now oc- 
cupied by private enterprise is fraught with grave dangers. 
Other writers regard the system as wholly corrupt, and hope 
to see it replaced either by a system under which all eco- 
nomic activities are minutely regulated by government, or 
by one in which the government itself carries on all pro- 
duction of wealth in behalf of society as a whole. 

An exhaustive treatment of these opposing views would 
carry us far beyond the scope of the present work. We may, 
however, consider briefly whether the system of free enter- 
prise meets the tests of justice and of social expediency. If 
it does this in the main, there may yet be a distinguishable 
field in which individual enterprise should be subjected to 
governmental regulation, and yet another field in which 
the government should participate in the production of 
wealth. A part of our task must be to find the boundaries 
of the respective fields, if such boundaries really exist. 

We may first inquire whether the existing system 
tends toward justice from the point of view of those who 
direct production, the class of enterprisers. Any enterpriser 
may engage in any branch of production, and create and 
sell wares to his best advantage. Any enterpriser may make 
a calculation of costs and prices in the various branches of 
production. If prices are high in any one field, relatively 



320 INTRODUCTORY ECONOMICS 

to cost, new enterprisers press into the field ; the supply of 
the commodity is increased, and its price falls. It follows 
that there is a tendency for the various classes of goods to 
exchange, one for the other, in proportions corresponding 
with their respective costs of production. When this point 
has been reached, justice, as between different enterprisers, 
has been established. 

At any given time, it is true, some enterprisers receive 
greater rewards, in proportion to their outlays, than others. 
But if competition is free, this can happen only when not 
enough of one commodity is produced and too much of an- 
other. The high rewards given to enterprisers in the one 
field are an inducement to the expansion of production in 
that field ; the low rewards in another field give warning that 
less of the product of that field is wanted by society. The 
unequal treatment of enterprisers is the means by which 
society compels them to direct their forces in such a way 
as best to meet society's needs. The inequalities are salutary 
in their effects; when there is no longer an improper dis- 
tribution of productive energies, they cease to exist. 

In a similar way, the system of free enterprise tends to 
establish justice as between different classes of workmen. 
If in any industry wages are above the average, due allow- 
ance made for relative agreeableness and safety of employ- 
ment, labor tends to flow into the industry from industries 
in which wages are below the average. Wages fall in the 
former industry and rise in the latter. The initial inequali- 
ties in wages signified that there was too much labor in some 
fields, too little in the others, and the very fact of inequalities 
of reward helped to correct this condition. Justice is done 
as soon as social expediency permits. Similarly, there is a 
tendency toward equality of rewards for invested capital. 

Can it be said that the system of free enterprise insures 
justice in the relations of enterprisers, capitalists and labor- 
ers with one another? There is no way of weighing the 
3acrifices undergone by those who direct industry against 



INTRODUCTORY ECONOMICS 32 1 

the sacrifices of those who furnish capital and of those who 
labor. We can, however, weigh the services to society of 
the respective classes; and we can say that there is a ten- 
dency for rewards to proportion themselves to services. This 
is not exactly equivalent to saying that the distribution thus 
based on services is just. For how came the milHonaire into 
a position where he can serve, as it were, by proxy, his mil- 
lions bringing him great rewards, while the laborer, serving 
in person, receives but an insignificant return? From the 
point of view of social expediency, however, it seems more 
plausible that a distribution based on service is satisfactory. 
Assuring to the capitalist the fruits of his capital encourages 
the formation of new and greater capitals, and these are 
powerful instruments for increasing the social production 
and hence for improving the economic condition of all. 

An economic system based upon free contract will be 
just and socially expedient only when the parties to each 
contract stand on a footing of substantial equality. In the 
first place, the buyer must know the properties of the goods 
offered to him as well as the seller knows them ; the laborer 
must know the risks and inconveniences attaching to a given 
employment as well as the employer knows them. When an 
unscrupulous horse dealer foists upon an unsuspecting buyer 
an animal with a hereditary taint of character or defect of 
body, the social welfare is in some degree reduced. The 
seller receives wealth, not for his services, but for his rascal- 
ity ; the buyer parts with his money, not for utilities, but for 
''experience." If all trade were of this nature, as it was 
among the ancient Greeks, we should, like the ancient Greeks, 
regard trade and piracy as twin callings. 

In the second place, the buyer must be in a position to 
deal with any one of several sellers, each acting indepen- 
dently of the others, and the seller must be able to offer his 
wares to any one of several independent buyers. The laborer 
must have the option of selling his services to any one out 
of a number of independent employers, and the employer 



322 INTRODUCTORY ECONOMICS 

must have the option of selecting from among a number ^of 
workmen. In other words, competition must exist on both 
sides. Otherwise the seller or the buyer, the laborer 
or the employer, is in danger of being forced to accept 
terms that are manifestly unfair. And this can issue 
only in the discouragement of production, and hence in eco- 
nomic decay. 

Of the two conditions stated, the latter — the existence 
of competition — is the more important. If competition is 
active, the seller of wares will point out their good qualities, 
and his competitors will point out their bad ones. Even an 
ignorant buyer is thus in some measure protected against 
injustice. When one party to a contract has no competitors 
to fear, knowledge on the part of the other party is of little 
avail. There is a certain town which I can reach only by 
traveling over a particular railway line. The line is in very 
bad shape ; the ties are rotten and the rails are light ; the 
cars are old and unsanitary. Travel on this line involves 
an unduly large measure of danger and discomfort, and I 
know it. Yet I must buy tickets over the line, because I 
have no alternative. 

Now, if there were merely sporadic cases in which con- 
tracts are made under conditions that make possible a wide 
departure from fairness, there would be little need for gov- 
ernmental intervention. But when there is an extensive field 
in which such conditions prevail, the need for governmental 
intervention becomes imperative. The government must reg- 
ulate the conditions and terms of economic contracts when 
its failure to do so results in substantial injustice. 

In early times the producer and the consumer were, as 
a rule, neighbors. The tailor and his customer lived in the 
same village. If then the tailor worked under unsanitary 
conditions, the customer had a chance of knowing it. If the 
tailor substituted inferior materials, trusting to the custom- 
er's ignorance, the deception was likely to make itself known 
in the wearing of the garments, and react unfavorably upon 



INTRODUCTORY ECONOMICS 323 

the tailor's business reputation. Fair dealing, under the cir- 
cumstances, was a prerequisite of business success, and the 
man who dealt dishonestly sooner or later reaped the due 
harvest of his misdeeds. 

To-day the man who makes your clothes may live a 
thousand miles away from you. He may be suffering from a 
mild attack of smallpox as he works upon your garments. 
You cannot see the danger that lurks in them. The milk that 
you drink may come from a dairy one hundred miles away, 
where no attempt is made to prevent its contamination with 
the germs of disease. The appearance of the milk gives you 
no warning of the fact. Patent medicine manufacturers may 
for years have supplied you with remedies containing dan- 
gerous amounts of opium; packing houses may have fur- 
nished you with meat treated with preservatives that under- 
mine your health. Only an expert can tell you whether this 
is true or not ; and you can probably ill afford to employ a 
corps of experts to investigate the hidden qualities of the 
things you buy. 

The workman in a large factory is in a similar position 
of helplessness. He cannot estimate the degree of danger 
that unfenced machinery represents. He cannot tell whether 
ventilation is adequate, or whether dust and noxious gases 
are properly disposed of. Furthermore, he is often unable 
to judge correctly as to the number of hours that he can toil 
daily without undermining his health. 

Not less significant than the separation of consumer 
from producer has been the development of combinations of 
producers. In many fields, buyers have virtually only one 
seller to deal with. In this state of affairs, there is no way 
in which the consumer can enforce a demand for wares of 
good quality, if wares of poor quality are more profitable. 
The employee of a monopoly may know that unsanitary con- 
ditions prevail in its shops, but he may be unable to find other 
employment. Furthermore, the prices of monopolized prod- 
ucts are almost certain to be unreasonably high, and this 



324 INTRODUCTORY ECONOMICS 

means that the monopoHst takes from the aggregate income 
of society a larger share than his services warrant. 

There is, then, a field in which governmental regula- 
tion is necessary. ( i ) The government may be called upon 
to regulate the qualities of products or of services. (2) It 
may be called upon to regulate the prices of commodities or 
services. (3) The government may regulate the conditions 
under which work is performed. (4) It may regulate wages. 
(5) It may regulate the relations between the enterpriser 
and the men who provide him with capital. 

Governmental regulation of the quality of commodities 
was exceedingly common in the Middle Ages. The weight 
of the loaf of bread, the width and quality of fabrics, were 
determined by public authority. With the development of 
modern industry much of this regulation fell into disuse. 
Competition was permitted to regulate the quality of com- 
modities as it regulated their prices. The mediaeval kind of 
regulation has, however, survived in a few instances, where 
the retention by a country of a valuable branch of trade for- 
bids individualistic tampering with the traditional standards 
of quality. The Persian Government endeavors to suppress 
the use of aniline dyes in the manufacture of rugs, on the 
ground that the employment of these dyes will ultimately 
destroy the foreign demand for Persian rugs. The Japanese 
Government inspects all mattings produced for export, and 
regulates their quality. 

The regulation of the qualities of goods in most modern 
states has for its chief purpose the preservation of the public 
health. The use of certain ingredients in foods is forbidden ; 
the use of other ingredients is limited to certain fixed pro- 
portions. An attempt is made to insure the production of 
many classes of goods under conditions limiting the risk of 
transmission of disease from worker to consumer. No at- 
tempt is ordinarily made to protect the consumer against 
fraud, so long as such fraud does not involve injury to 
health. 



INTRODUCTORY ECONOMICS 325 

The regulation of qualities is carried farther in the case 
of certain goods and services furnished by enterprises en- 
joying a monopolistic position. The quality of gas to be 
furnished to the inhabitants of a city by a private company 
is commonly determined by public authority. The service 
of passenger transportation by street and steam railways is 
often subject to regulation as to quality. In these cases 
regulation is often defended on the ground that the enter- 
prises are of a quasi-public nature. But any enterprise which 
obtains a monopoly of a branch of production is, from an 
economic point of view, in the same position. If a powerful 
monopoly controlled the iron and steel business of the United 
States, there would be no way, except governmental regula- 
tion, of preventing the use of ores rich in phosphorus or 
sulphur in the production of iron destined to be transformed 
into steel rails. This would be a menace to the safety of all 
travelers; it would therefore be necessary in the end for 
government to regulate the quality of steel produced. 

There is, of course, a danger that the government may 
go so far in the regulation of qualities as to check legitimate 
improvements. By the aid of certain chemicals, wheat flour 
of a darker color than consumers like may be bleached to 
a snowy whiteness. The chemicals are admittedly injurious 
to health; but they are inevitably driven off, either in the 
process of flour manufacture or in the baking of bread, so 
that hardly a trace of them can be found in the latter prod- 
uct. Yet there is some public sentiment in favor of prohibit- 
ing the bleaching of flour. At the present writing California 
fruit growers are greatly concerned over an administrative 
ruling which limits so narrowly the use of sulphurous acid 
in the curing of dried fruits as to threaten the ruin of the 
dried fruit industry. In spite of the danger of over-regu- 
lation, however, it must be admitted that the principle of 
regulation of quahties is salutary, and that the scope of regu- 
lation is destined to extend itself in future. 

Governmental regulation of the prices of commodities 



326 INTRODUCTORY ECONOMICS 

and services v/as also exceedingly common in the Middle 
Ages. In modern times such regulation is limited to the 
field of the so-called quasi-public enterprises. The charges 
of railway companies, of gas and electric light companies, 
of telephone and telegraph companies, and even of such 
petty enterprises as the carriage of passengers in cabs and 
similar conveyances, are commonly regulated by law. 
Such regulation is not actually based upon any economic 
ground at all, but upon the legal ground that the enterprises 
in question use the public highways, or employ public powers 
in obtaining rights of way. 

From an economic point of view, all the enterprises 
mentioned except the last ought to be subject to govern- 
mental price regulation, because they are monopolies. With- 
out such regulation, a railway company might, if it chose, 
levy such heavy charges upon the carriage of goods away 
from and into a particular locality as to destroy the business 
of that locality and reduce the value of property situated 
there to almost nothing. If the railway is the only means of 
transportation from a mining district, by raising rates it 
could reduce the profits of mine owners to nil and force the 
closing of the mines. It could then buy up the mines at a 
very low figure, and operate them profitably on its own 
account. True, this is an extreme case; yet it illustrates 
very v/ell the evils that an unregulated monopolistic deter- 
mination of transportation charges would entail. 

If a monopolistic combination succeeded in gaining con- 
trol of the entire iron and steel industry, or of the business 
of mining coal, its powers for extortion would be as great 
as those of the railway in our example. What would one 
give rather than pass a Northern winter without co^l ? Not 
all that one has, but a good part of it. If we must inevitably 
see an extension of monopolistic enterprise, as many believe, 
it is inevitable that we shall see an extension of the principle 
of governmental price regulation. 

So long as economic organization remained simple, 



INTRODUCTORY ECONOMICS 327 

there was comparatively slight need for a governmental reg- 
ulation of the conditions under which labor was performed. 
A large proportion of those who toiled were their own 
employers, and these could be counted upon to keep their 
workplaces in tolerably sanitary condition, and to limit their 
hours of labor and the intensity of their exertion in the 
degree that considerations of health demanded. Those who 
worked for wages enjoyed, as a rule, conditions as favorable 
as those of the workmen who were in their own employ. 
The advent of the factory system changed conditions materi- 
ally. Men, women and children were congregated in great 
masses, under the direct supervision of overseers many of 
whom v/ere bent upon getting the maximum possible service 
from the workers under them. Machinery took a place in 
the productive series, and the workers were forced to adapt 
themselves to the speed of the machines. Competition be- 
tween manufacturers led at first to a longer and longer 
working day,, and to greater and greater intensity of effort. 
The worker, seeking employment, was in no position to stip- 
ulate that the v/orking day should be limited to a reasonable 
number of hours, or that the labor should not be so intense 
as to be destructive of the health of the laborer. 

Society, it is clear, cannot afiford to see the vitality of its 
working classes sapped in an effort to raise to its maximum 
the annual production of wealth. An individual employer 
may profitably pursue the policy of hiring a set of workmen, 
wearing them out in a few years, and replacing them by 
another set. From the viewpoint of society this policy is as 
wasteful as it is cruel. The daily exertion of each man 
should be restricted in such measure that he may live a life 
of normal length, enjoying the normal number of years of 
health and usefulness. Where labor involves little strain, 
a man may work ten hours or more a day without injury to 
health. Where the strain is great, eight hours may be an 
unduly long work day. 

When laborers are associated in strong unions, they may 



328 INTRODUCTORY ECONOMICS 

be able, without governmental aid, to reduce the hours of 
labor in the measure that is desirable from a social point of 
view. Each organization is composed of workers of all ages ; 
and there is a natural tendency to maintain a pace that is not 
too rapid for the older workers, hence not so rapid as to 
destroy the physical health of the younger men. 

But strong trade unions control only a small part of 
the economic field. Such associations are especially weak 
in industries employing large numbers of women and chil- 
dren ; and these are precisely the classes that are most seri- 
ously injured by long hours of work. Hence it has come 
to be generally recognized that the conditions under which 
women and children work in factories ought not to be left 
to free contract. Hours of labor, for these classes, must be 
regulated by government. 

In almost every modern state some attempt is made to 
regulate by law the hours of labor of children employed out- 
side of the household. Such regulation has been carried 
farthest in the states where the system of large scale produc- 
tion has long been established, as, for example, in England. 
In new industrial states, as in Japan, the regulation of the 
hours of child labor is only in its inception. 

The regulation of hours of labor of women employed 
under similar circumstances is also a well established policy 
in the more advanced states. In the United States a serious 
obstacle to such regulation is found in constitutional provi- 
sions, originally designed to secure the liberty of the indi- 
vidual, but now operating in such a way as to obstruct his 
chances of attaining freedom from industrial slavery. The 
regulation of hours of labor of men has as yet made com- 
paratively slight progress ; the policy is, however, destined 
to extend its scope in the future. 

The regulation of other conditions of employment — 
ventilation, sanitation, etc. — ^has encountered comparatively 
few positive obstacles. The field is, however, so wide, and 
the work of legislatures so slow, that hundreds of thousands 



INTRODUCTORY ECONOMICS 329 

of workmen are to-day employed under conditions involving 
needless risk of mutilation and death. Still greater is the 
number employed under conditions that predispose the 
worker to disease. Progress in the direction of regulation 
of such conditions is steady, but dishearteningly slow. 

The regulation of wages is a policy very seldom em- 
ployed in modern times. Doubtless there are many cases 
in which wages are far below the level of productivity of 
labor; and in these cases it is manifest that injustice is 
done. To attempt to fix wages by law, however, is to en- 
counter grave difficulties. If in any industry wages were 
fixed at a level that seemed to the workers too low, the lat- 
ter would feel justified in refusing to work. If the level of 
wages seemed to employers too high, they would feel justi- 
fied in closing their shops. To force the laborers to abide 
by the rate determined by government would be to inaugu- 
rate an era of universal serfdom. Men would be compelled 
to work, on terms fixed by others ; and this is the essence of 
serfdom. To force employers to continue production, paying 
wages that seem to them unduly high, would be to confiscate 
property. In either case it is likely that economic progress 
would be checked. 

This does not mean that it would not be possible to se- 
lect certain industries, in which the laborer is most seriously 
exploited, and establish minimum wages there. If the rate 
were too low, some of the laborers could seek other employ- 
ment. If the rate were too high, some of the employers 
could remove their capitals to other industries. With the 
shrinkage in the volume of the industry, the price of its 
products would rise, and this would enable the remaining 
employers to pay the rate of wages fixed. True, some of 
the workers formerly in the industry would be left without 
employment. Some means would have to be found for 
transferring them to other employments. However this 
might be, such regulation, limited to a few fields, would 
encounter no insuperable obstacles, and might result in alle- 



330 INTRODUCTORY ECONOMICS 

viating the distress of some of the most helpless members of 
society. Some such policy as this has been inaugurated in 
one of the Australian colonies — with what results, we shall 
better know after the lapse of another decade. 

Regulation of the relations between enterpriser and cap- 
italist, or between borrower and lender, tenant and land- 
lord, has largely fallen into disuse. In modern times the 
man who borrows capital is usually possessed of some prop- 
erty and of at least an average degree of business capacity. 
It may therefore be taken for granted that he will not sub- 
scribe to terms that are not to his advantage. If a man is 
willing to borrow capital at ten per cent., there is good 
reason for believing that the annual use of the capital is 
worth at least $io per $ioo. Accordingly, there is no reason 
why the public authority should interfere in the transaction. 
Many of our States do indeed have usury laws, limiting the 
rate of interest that may be paid. But these laws are easily 
evaded, and may be regarded as obsolete. 

Where the enterpriser is a corporate body, as is com- 
monly the case in large scale production, the relations be- 
tween those shareholders who are actually in control and 
those whose voice in the management is seldom heard, often 
require regulation. The small investor in a large corpora- 
tion is often at the mercy of a circle of large investors, who 
manage the property in their own interests, not in those of 
the entire body of stockholders. Something akin to the con- 
fiscation of property takes place when the men in control 
of a corporation undertake a "shaking out" of the "little 
men." There is probably no class in the United States to-day 
more in need of governmental regulation than these "little 
men." In the end, doubtless, regulation will come, and the 
small investor in a corporation's stock will know whether he 
is buying property or shadowy hopes ; and whether or not 
he will be permitted to keep what he has purchased. 

Relations between landlord and tenant assume the guise 
of a social problem wherever the ownership of land has 



INTRODUCTORY ECONOMICS 33I 

become divorced from its cultivation. Where a small num- 
ber of large landholders deal with a vast number of small 
tenants there is often opportunity for the oppression of the 
latter. The tenant who brings a tract of land into an excel- 
lent state of cultivation cannot at any time carry the fruits 
of his labor away with him. Justice demands that he shall 
be permitted to retain his occupancy of the land until he has 
reaped the fruits of his labor. Upon the renewal of his 
lease he should not be compelled to pay an additional sum 
for the use of the productive powers that he has himself 
created. A wise landlord, it is true, will not deal unjustly 
with tenants who increase the productive power of his land; 
but not all landlords are wise. The tenant may, in some 
measure, safeguard his interests by the terms of the con- 
tract under which he enters upon his tenancy; but not all 
the conditions that may arise during a term of tenancy can 
be covered by a contract. Accordingly, the State, under the 
conditions assumed, may be called upon to regulate the rela- 
tions of landlord and tenant in such a way that the latter 
may proceed confidently with the improvement of the land, 
knowing that he cannot be deprived of his due reward. No 
problem of this nature has arisen in the United States. This 
is due to the fact that it is easy for any energetic cultivator 
to acquire land of his own. It is quite conceivable that at 
some future time, when the rising price of land and the 
resultant concentration of holdings have given rise to a per- 
manent class of tenant cultivators, the regulation of the 
relations of landlord and tenant will assume great impor- 
tance. 

The foregoing survey is sufficient indication of the 
fact that the regulative activities of government already 
cover a wide field; and we have excellent reason for be- 
lieving that the scope of such activities will in the future 
be greatly extended. In so far, we are drifting away from 
an economic system based upon free private enterprise. It 
cannot be said, however, that the essential nature of the 



332 INTRODUCTORY ECONOMICS 

existing economic system is thereby altered. That system 
is based upon private initiative; and though the govern- 
ment may restrict the field in which private initiative finds 
exercise, it does not bind initiative itself. The government 
may prohibit the production of certain articles. In so doing 
it warns private enterprise away from a limited field; but 
there remain other fields open. The government may fix 
the price at which a certain article may be sold, but this price 
must be left high enough to tempt private enterprise into the 
field; otherwise the article will not be produced. The 
government may prohibit the employment of certain classes 
of persons, and restrict the hours of labor of other classes. 
Private enterprise is still called upon to furnish employment, 
and the conditions may not be made so onerous as to exclude 
the possibility of liberal profits. A system of regulated enter- 
prise is none the less a system of private enterprise. A 
range of choice and an opportunity for gain are left open 
to the enterpriser, and if enterprise is really active, it is 
forever creating new opportunities beyond the reach of 
regulation. 

It may appear that while the existing system of eco- 
nomic organization is in no danger of subversion through 
the extension of governmental regulation, it is in danger of 
being supplanted by a system of governmental enterprise, 
or a socialistic state. We have already many examples 
of direct production of commodities and services by the 
state; and we may predict an increasing number of such 
enterprises for the future. Must we therefore believe that a 
time will come when the state will enter all branches of 
industry, and organize the whole working population as a 
civil service corps? We shall get some light upon this 
question from a study of the reasons that have led to the 
direct participation of government in industry. From such 
a study we may draw reasonable inferences as to whether or 
not the same reasons will lead to an indefinite extension of 
the principle of governmental enterprise. 



INTRODUCTORY ECONOMICS 333 

In some instances, the production of a commodity or a 
service is undertaken by government solely with a view to 
securing a revenue. This is the case with the tobacco mon- 
opoly of France and of some other countries, the salt mon- 
opoly in British India, and a few other public monopolies. 
The profits of the business take the place of revenues that 
would otherwise be raised by taxation. The government of 
France, instead of operating a tobacco monopoly, might levy 
duties on the manufacture and sale of tobacco. If the policy 
of a government monopoly is resorted to, the product is sold 
to the public at a price exceeding cost of production. This 
excess of price represents the net revenue. Let us say that 
in a given country the price will be so high as to yield a 
net revenue of $20,000,000. Now, the government might 
place a tax yielding $20,000,000 on the private manufacture 
of the article. The manufacturers would add the tax to the 
price paid by the consumers. In either case the government 
would get the same revenue. In either case the consumer 
would bear the burden. Which is the better policy, then, a 
government monopoly or a tax yielding the same revenue? 

Under private enterprise the price of tobacco will be 
determined by cost of production plus the tax. Say that the 
aggregate cost of production of all the tobacco used in the 
country is $40,000,000. Add to this a tax of $20,000,000, 
and the consumers will have to pay about $60,000,000 for 
it. Under government enterprise, what will it cost to pro- 
duce the tobacco? The government can borrow capital at 
a lower rate than private enterprisers; it is likely to pay 
higher wages. Laborers in the employ of the government 
are not likely to work so hard as those in the employ of 
private persons. Let us therefore say that the production of 
tobacco costs the government $50,000,000. To this add 
$20,000,000 profit for the public revenues, and the con- 
sumers will have to pay $70,000,000 for what they would 
have paid $60,000,000 under private enterprise, subject to 
excise taxation. 



334 INTRODUCTORY ECONOMICS 

From this example the following principles may be 
drawn : When the cost of production in governmental shops 
is greater than the cost in private shops, with a given burden 
upon the consumer a larger revenue can be obtained by the 
government through taxation than through governmental 
enterprise. The cost of production is ordinarily greater in 
governmental shops than in private shops. There is accord- 
ingly little reason for an expansion of governmental enter- 
prise for the sake of obtaining revenue. 

The government may assume control of an industry for 
the purpose of regulating the quality or the price of the prod- 
uct. The assumption by governments of the sole right to 
coin money is a case in point. Imagine the inconvenience 
of a currency composed of coins struck by all the private 
companies that mine gold or silver! Some would be light 
weight, some heavy; some would have much alloy, some 
little. Obviously, absolute uniformity, and absolute con- 
formity to well-known standards, are essentials of a currency 
employed in a modern state. And such uniformity and in- 
tegrity of quality can be secured only when the coins are 
issued by an organ of society which regards the interests 
of society as paramount. Doubtless it costs more to coin 
money in government establishments than it would cost in 
private establishments. But this waste is insignificant as 
compared with the gains from a currency of unquestioned 
soundness. 

A similar reason has led to the nationalization of the 
railway in many countries, and to a popular demand for 
nationalization in other countries. If we could be sure that 
private railways would furnish good service, at equal terms 
to all, and at reasonable charges, we should never regard 
government ownership of railways as desirable. But of this 
we cannot be sure. We have tried regulation, and are still 
trying it; and it may be that we shall succeed in our en- 
deavors to secure impartial and reasonable treatment of ship- 
pers and travelers. If we cannot do this, we shall in the 



INTRODUCTORY ECONOMICS 335 

end make up our minds that the railway is to other 
business enterprises what the coinage is to other com- 
modities — an essential link in almost every business trans- 
action — and that its social aspects are of paramount 
importance. 

A similar argument applies to the so-called municipal 
monopolies — street railway transportation, the furnishing of 
water and light, and the telephone service. If it is impossible 
to regulate the quality of service and the charges under 
private management, public management becomes necessary. 
It is, however, to be borne in mind that such regulation is im- 
possible only when the people are unable to select able and 
honest officials; and when such is the incapacity of the 
people, government enterprises stand little chance of being 
managed efficiently and honestly. 

In the foregoing instances, there is no inherent neces- 
sity for public operation of industry. In the first case this 
policy is adopted in lieu of a policy of taxation ; in the other 
cases, in lieu of a policy of regulation. We come now 
to consider cases in which government enterprise is neces- 
sary, because it is the only means of securing certain impor- 
tant utilities for society. 

In some branches of industry, practically all the utilities 
created embody themselves in a concrete form, so that the 
producer is able to recoup himself for his costs of production 
through sale of the utilities to those who are to enjoy them. 
The utilities created by a shoe manufacturer are embodied in 
the shoes; and the manufacturer can obtain from the user 
of shoes a price that will compensate him for his expenses. 
If the consumer will not pay enough to cover costs, the shoes 
ought not to be made, for there are no utilities arising from 
their making that the consumer cannot appraise. 

We may contrast with the utilities furnished by such 
an industry the utilities furnished by a lighthouse. These 
are scattered far and wide over the waters that are rendered 
safe by the light. They benefit every shipowner whose vessel 



336 INTRODUCTORY ECONOMICS 

sails in these waters ; every passenger for whom the danger 
of death at sea is thereby reduced ; every shipper, who pays 
lower freights because of the smaller chance of the founder- 
ing of ships. In a year's time the utilities contributed by the 
lighthouse may far exceed its cost of maintenance. But if 
you or I were to erect a lighthouse, how would we collect 
pay for these utilities from the beneficiaries? Clearly, this 
is no field for private enterprise, and yet it is a field in which 
labor and capital may produce greater utilities than else- 
where. The government, as the representative of society, 
can alone afford to exploit this field. 

Again, an industry may produce some utilities that are 
concrete and appropriable, and some that are elusive, flowing 
freely to persons who cannot be made to pay for them. In a 
very slight degree this is true of all industries ; but we are 
concerned only with cases in which this differentiation of 
Vitilities is well marked. We may take as an example com- 
mon school education. The children who receive instruction 
are the immediate beneficiaries ; they, or their parents, could 
be made to pay something for it. But all of us who wish a 
government of officials selected by intelligent voters ; all of us 
who prefer intelligent and efficient employees to ignorant 
ones ; all of us who wish to enjoy the products of a rich and 
varied national production, are the indirect beneficiaries. A 
great part of the total benefit from educating a child is 
reaped by persons not connected with him by ties of blood 
or personal interest. 

Now, if the benefit to the child is so great, and so clearly 
appreciated by him or by his guardians, that the entire ex- 
pense of education can be met by tuition, we who are also 
beneficiaries may take our gains gratis. But if this is not the 
case — and, as a rule, it is not — we should be very short- 
sighted if we refused to contribute our share to the expense. 
From a social point of view the benefits of popular educa- 
tion far outweigh the expenses of it; the expenses cannot 
in each case be assessed upon the beneficiaries ; therefore the 



INTRODUCTORY ECONOMICS 337 

production of the utilities in question must be undertaken by 
government. 

Another case may now be cited. Near one of our large 
cities there is an island which is capable of providing build- 
ing lots for a large population. Until recently comparatively 
few persons could make the island their home, on account of 
the uncertainty and inconvenience of passage to the city. A 
ferry service existed, but the boats were small, old and slow. 
The owners of the ferry line could not furnish better service, 
however, because the increase in fares would not cover the 
increase in expense. 

The introduction of an efficient ferry service would 
have greatly increased the value of land on the island. It 
would have furnished an outlet to some of the surplus popu- 
lation of the city, and diminished the evils of overcrowding 
in tenements. These utilities might very well have been of 
sufficient annual value to offset the increased cost of service. 
But the private ferry company could collect no charge for 
such utilities ; therefore it could not make the improvement. 
The city, on the other hand, could very well afford to estab- 
lish a satisfactory service to the island, since the city as a 
whole would get most of these elusive benefits, in addition 
to the fares it would collect from passengers. 

It is obvious that the same principle may be extended 
to a great many enterprises — street railways, steam railways, 
etc. At any given time most of the utilities produced by such 
an enterprise as a street railway system may be of such a 
character that a price can be charged for them. As the city 
grows in size and questions of transportation assume greater 
and greater importance, the utilities that are not appropriable 
increase in number and in value. In the end, these utilities 
may come to be of such significance that the transit system 
ought to be managed chiefly with reference to them. In such 
case public ownership ought to take the place of private 
ownership. 

Now, as population increases the industries producing 



33^ INTRODUCTORY ECONOMICS 

non-appropriable Utilities, along with those that are appro- 
priable, become more numerous — or, more exactly, the non- 
appropriable element in utility production becomes more 
important, relatively to the appropriable element. Accord- 
ingly, an expansion of public enterprise, in this direction, 
seems probable. 

One further case in which public enterprise may enter 
the field of production may here be touched upon. Some- 
times private enterprise is not sufficiently daring or skillful 
to enter upon the supplying of utilities even when there is 
no obstacle in the way of charging a price for them. The 
government, if under the control of able administrators, may 
then increase the social welfare by undertaking production 
directly. When a country, long habituated to one mode of 
economic life, is suddenly compelled to adapt itself to new 
conditions, this superiority of public to private enterprise 
may manifest itself. In the last half century many enter- 
prises have been undertaken by the Japanese Government, 
in fields ordinarily left to private business. As a class of 
enterprisers developed, the control of such business has been 
gradually transferred to them. When, on the other hand, 
initiative dies out in a people, owing to the weeding out of 
the more intelligent and enterprising elements in the popu- 
lation, the government may gradually assume control of 
production and trade. Something of this nature occurred 
in the later years of the Roman Empire and in the declining 
period of Venetian history. 

So long as there remains in society a large class of 
persons possessing enterprise and ingenuity, there is little 
reason for believing that the extension of the field of public 
enterprise will really narrow the field of private enterprise. 
For the boundaries of the latter can be extended indefinitely 
outward, so long as men have wants that remain unsatisfied. 
Public enterprise will supplant private enterprise only when 
the latter has become impotent to direct the supplying of the 
needs of society. 



iAB 



l/ 



